The value of a business is usually a function of its earnings not its tangible assets. Depending upon the nature of the tangible assets, it is true that a buyer might be willing to pay more for a business with a lot of assets based on the idea that if all goes badly, the buyer can at least sell off the assets and recover some of the investment.
Three Approaches to Valuing a Business
There are three approaches to valuing a business. The first approach is known as the Asset Based Approach. This approach derives an indication of value based on the costs to replace the tangible assets in like-kind condition. If the earnings will not support a value greater than the assets, then at best, the value of a business it the value of its tangible assets.
The Market Approach derives indications of value using ratios or factors derived from the earnings, sales and/or assets of past transactions of similar businesses. These ratios or factors are then applied to the subject company’s sales, earnings and/or assets to derive an indication of value. Rules of Thumb are also considered to be a Market Approach method; however, Rules of Thumb are dangerous because they are not very specific as to how the conversion factors were derived and at best Rules of Thumb are based on averages. If the subject business is not average, then Rules of Thumb will not properly determine value.
The Income Approach derives indications of value by converting some level of earnings into a value using a capitalization rate, discount rate or multiple. There are about five Income Approach Methods that appraisers frequently use to obtain indications of value. Each of these methods requires some level of earnings and a conversion factor to convert the earnings into a value. Properly matching the selected level of earnings (pretax, after-tax, discretionary or some form of cash flow) with the correct conversion factor (cap rate, discount rate or multiplier) is the key to obtaining a reasonable and supportable indication of value. If done correctly, each of these methods should produce similar values.
Formula to Derive Indication of Value
Here is one Income Approach Method frequently used by business brokers and appraisers to derive an indication of value. It is known as the Multiple of Discretionary Earnings Method. This method is a two-step process.
First, you must determine the discretionary earnings likely to reoccur in the near future. This can be determined by either averaging the last several years or if your most recent year is indicative of what you expect to be on going, then you can use this past year's discretionary earnings. Discretionary earnings is defined as reported pretax earnings, plus your salary, interest expense, depreciation and any personal expenses run through the business.
The next step is to pick a multiplier. The entire range of multipliers applicable to this level of earnings is 0 to 3. Most small businesses sell in the range of 1.5 to 2.5 times the discretionary earnings. The resulting value includes all the tangible assets needed to operate the business such as the fixtures, furniture, equipment and inventory. Additional value that you can keep or sell is the net liquid assets (cash, accounts receivable less payables) and non-operating assets owned by the business such as your personal car. Thus, if a business generates discretionary earnings of $150,000 and the business is considered average, then 1.5 times $150,000 = $225,000 plus the value of the net liquid assets.
Seek Outside Help
As you can see, properly determining value is a difficult process. There are professional business appraisers who typically handle these types of transactions and I strongly suggest you hire a business appraiser to assist you in properly determining a value for the subject business. Two Web sites that provide a list of their designated business appraiser members are the American Society of Appraisers and the Institute of Business Appraisers.
By Jeff Jones
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