How to Buy & Value a Business - Part 3

1. Valuation Methods

The Institute of Realtors are recommending to all business brokers the use of three basic valuation methods to establish a market related value on a small to medium sized business.

Our firm have used these methods successfully in the market place for the last 15 years on SME's (Small, Medium Enterprises).

The three methods are as follows:

1. Extra Earning Potential [Super Profits]
2. Return on Investment [ROI]
3. Payback Period [Magic Multiplier]

Example:

Retail Business

Based on the above information, proceed as follows:

1. Extra Earning Potential

This method says that in exchange for the risk of being in one’s own business, a buyer should receive an extra amount over and above what he could earn if his money was placed in a bank and he worked for a salary.

Assets + stock

Asset Value:

Includes fixtures and fittings and plant and machinery that are unencumbered and any assets on lease or HP that have a value greater than the outstanding debt. Add the difference between market value of that asset less the outstanding balance to asset value. Stock is at cost. Debtors and creditors are left out of the calculation – see 7. Debtors & Creditors under Factors to Consider When Valuing A Business.

N.B. Property, whether residential or commercial and industrial must NOT be included in the asset value but rather valued separately by the appropriate expert.

Interest Percentage:

Calculated at the rate which an average person could attain from a financial institution, ie fixed deposit rate.

Salary:

The amount an owner would pay a manager to run the business.

N.B. If the business already has a manager, use his salary if realistic. The net profit should then be increased by the amount of the salary to bring it into line with the owner operated business.

Net Profit per annum:

The profit, after adding back all the perks that the seller takes out of the business.

EEP x [ ] years = Goodwill:

This is covered by one’s experience in the market place but as a rule of thumb the following can apply:

N.B. The period used could vary in different areas:

Value:

The asset value (a) and the goodwill (d) are added together.

The interesting part of this method is that it gives a higher value to businesses that have a large asset base, ie plant and machinery in engineering businesses.

2. Return on Investment [ROI]

This method sets the value based on a return an owner would expect for the risk of being in business after allowing for a salary.

Annual Net Profit:

As in EEP above, all the perks the seller derives from the business plus the profit.

Salary:

In this example:

R5 000 pm = R60 000 pa for a manager.

If already manager run, use the same process as EEP salary (shown earlier).

Expected %:

Somewhere between 40% to 45% before tax. The higher the risk of the business the greater percentage return the owner expects.

The lower and more stable the business, the less the return one would expect and consequently the higher the price one must expect to pay.

ROI:

The ROI value is therefore the actual net profit less salary divided by .40 or .45.

3. Payback Method

This method, sometimes referred to as the Magic Multiplier, bases the valuation on the period one would expect to recoup their investment times the net profit:

MONTHLY NET PROFIT R 15 000 x 15 months = R 225 000

With older, more established businesses with a high asset base, the period could be from 15 to 18 months.

Younger businesses and particularly service orientated concerns, anything from 9 to 12 months.

N.B. established franchises do command a premium.

AVERAGE VALUE

This is the total of the methods divided by three.

Over the years, it has been found that although the three methods might vary substantially in their individual valuation results. An average tends to balance out the variables and is normally closest to a realistic market related value.

AVERAGE VALUE of above valuations

N.B. This is the total market related value including stock.

Therefore, after taking into account all the factors affecting value, a buyer should expect to pay this price.

Simple, yes.

But be careful, don't confuse value with price.

Value

Is what a business should be worth to you.

Price

Is what you agree to pay for it.

How close the price comes to your valuation will depend on your negotiation skills or those of your broker. So at this point the determination of value will only serve as a guide.

Most often you will have the opportunity of acquiring a business for less than your valuation and other times you may have to go beyond your value to finalise a transaction.

This is when other elements affect the process, i.e:

Just as a rule of thumb:

When making a cash offer on a business, start your negotiation on the following basis:

Example:

Your Value (approx) R 285 000

Opening Offer

1. Other Buy Competition (20%) R 228 000

2. Upper Hand (30%) R 199 500

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