were too low, deduct the shortfall from your profit figure.7 Deduct any additional expenses that you know you’re likely to have.One of the things that often happens when a business is for sale is that everything is a bit run-down and hasn’t been properly maintained. In the example in Figure 3-1, I add an extra $4,000 a year for the amount I think should have been paid to keep everything in reasonable condition.
8 Adjust the profit for any irregular or unusual income and expense items.Trawl through the financials. You’re looking for irregular income such as large insurance claims or capital gains, and you’re also searching for unusual expense items such as moving expenses, compensation claims or capital losses.
9 Calculate the average profit for the period you’re analysing.You know the deal. If you have three years’ worth of figures, add the final profit for each year together, and divide this total by three.
10 Note down the final value: You’ve now calculated the average Adjusted EBITDA.Now that you’ve calculated EBITDA, you’re ready to make an estimate of what the business is actually worth. Read on to find out more …
FIGURE 3-1: Calculating average profit (also known as EBIT).
Valuing an Existing Business
So, how much is a business worth? At the end of the day, a business is only worth what a buyer pays for it. Until this value is known, figuring out the real worth of a business is an odd mix of accounting, gut-feeling and the weighing up of probabilities, with a hotchpotch of possible valuation methods all offering different takes on the subject. Experienced valuers often prefer to value a business using a couple of different methods, arriving at an average of the results as their final opinion.
The times earnings method
When you know what the Adjusted EBITDA of a potential business is (refer to the previous section to refresh your memory on how to calculate EBITDA), you’re ready to calculate how much moolah this business opportunity is really worth.
The times earnings method is based on the idea that you multiply the Adjusted EBITDA by a times earnings multiplier to arrive at an overall valuation of goodwill. (If a business has debtors, equipment, furnishings or inventory, you add the agreed value of these assets to this goodwill figure.) Typical multipliers can range from two to six times Adjusted EBITDA. For example, if a business had an Adjusted EBITDA of $100,000 and your accountant recommends a multiplier of four, the total value of goodwill for the business would be $400,000. So, the price for the business would be $400,000, plus the value attributed to debtors, equipment, furnishings or inventory.
Listed companies typically sell for a higher multiplier than private companies, and can even sell for up to ten times EBIT.
If a business is suffering downwards sales trends, selling in a rush or operating without a secure lease, it may sell for as low as one or two times EBIT.
An asking price anywhere between two and six times EBIT is reasonable for a private business.
A service business that relies heavily on an owner’s specialist skills may receive a lower EBIT, due to the fact that the owner’s skills are hard to replicate.
If the profitability of a business is growing, and the owner can prove sustained growth trends, the owner may well ask for a higher EBIT.
The capitalised earnings method
This approach to valuing a business provides another way to skin the same cat, and is called the capitalised earnings method. This method is more commonly used by the buyer rather than the seller, because the final valuation is so reliant on the rate of return that the buyer requires.
Here’s how it goes:
1 Work out the EBITDA.Sounds like I’m rapping. But no, I’m actually talking about Earnings Before Interest and Tax, Depreciation and Amortisation. I explain this calculation in the section ‘Calculating the ‘True’ Earnings of a Business’, earlier in this chapter.
2 Decide what you want as your rate of return.This figure is usually how much you’d get from the current bank deposit rate plus an allowance for the risk you’re taking. For example, if the deposit rate is 2 per cent, you may want to add another 8 per cent for the risk you’re taking, and so decide to aim for 10 per cent as your rate of return. (My example here reflects the rates at time of writing, which are historically low. Of course, deposit rates may have changed by the time you’re reading this.)
3 Divide the EBITDA by your desired rate of return.The result of this calculation is called capitalised earnings. For example, if the average EBITDA of a business is $50,000 and you want a return of 10 per cent, capitalised earnings would be $500,000. Or, if you want a return of 15 per cent because your perceived risk is higher, capitalised earnings would be $333,333. This capitalised earnings figure represents how much the business is worth in your eyes, given the rate of return that you’re seeking. As the examples show, the business valuation goes down as the risk (and so required rate of return) goes up.
The strategic advantage method
Sometimes a business sells for way more than it would be worth if it were valued by traditional methods, because it possesses some kind of strategic advantage that the buyer can leverage to great success. For example, a major player in a particular market may be happy to pay big bucks for one of the smaller fish in the pond because they want to get their hands
