Valuing a small business for sale purposes

Valuing a small business for sale purposes

The value of a business is determined by the expected future net cash flow it generates.

With large businesses, the timeframe over which the cash flow is measured is often 10 to 20 years. The time value of money is such that Discounted Cash Flow (DCF) methods become more relevant over the longer term.

With small and medium enterprises, the relevant time frame is usually shorter. Simple cash flow and payback periods are more useful, as outlined in the methods below.

1.  Valuation based on Capitalisation of Earnings Method

We use the Capitalisation of Future Maintainable Earnings method to arrive at a base market value of the business.

The level of expected future maintainable earnings should take into account a number of factors, including the consistency of past results, whether earnings are increasing or decreasing and possible threats to future results.

Adjustments are made for non-relevant events and also to remove finance, depreciation and unrelated costs.

Although future maintainable cash flow is taken before depreciation, allowance should be made for future capital replacements.

This method of valuing a small business is similar to the way commercial property is valued. A commercial property earning net rental income of $1M may be simply valued by applying a capital rate of, say 10% to produce a capital value of $10M.

With a small business, the principal is the same. The Net Profit before finance, depreciation and owners’ salary and benefits is often the starting point. From the Net Profit is deducted the equivalent salary of all working owners, as well as a provision for capital replacement, to arrive at Earnings Before Interest and Tax (EBIT).

This is the equivalent of the net rental return on a commercial property, as the profit in both cases is after taking into account all labour inputs.

With a small business, the required pre-tax capitalisation rate of return is usually higher than on real estate. Investing in a small business is inherently riskier than investing in bricks and mortar. Just ask the banks!

A benchmark return for general business is 25-30%. This rate may be lowered for businesses with lower perceived risk and raised for others.

A small business with an EBIT of $1M is worth about $3.3M at a capitalisation rate of 30%. i.e. someone may be willing to invest $3.3M to earn $1M pa. (Calculation: $1M / 30% return = $3.3M.

The base value of a business under this method includes net working capital:

Net working capital = Stock + Debtors – Creditors

Calculations comparing property and business valuations are set out in the following table:

Future MaintainableNet Profitper the Trading Accounts $1M $1.2M
Add  normalisation adjustments (if any)
Net Profitbefore finance costs, tax, depreciation & Owners’ costs $1.2M
Less allowance for Owners’ labour input $(100K)
EBITDA (Earnings before interest, tax, depreciation & amortis’n) $1M $1.1M
Less Provision for Capital Replacement $(100K)
EBIT $1.0M
Divided by Capitalisation Rate (ie required return on investment) 10% 30%
Estimated Base Market Value of the Business

2.  Valuation based on the Net Realisable Value of Physical Assets

Where physical assets in the business are substantial or where the profit is small, the value of the physical assets may exceed the value of the expected future cash flow stream.

Plant & Equipment employed in the business should be itemised and valued. Assuming that the values are realistic, then this, plus the value of inventory, can be taken as the base value of the business.

Base Value of the business

The base value of the business is the higher of the value under the Capitalisation of Earnings method and the Net Realisable Value of the physical assets.

Goodwill, if any, is simply the amount by which the value of the cash flow exceeds the value of the physical assets.

The value of a business to a purchaser may be less than the business owner believes is a fair value because the business owner does not build in the same risk factors as purchasers do for unknowns and lack of familiarity with the business. Similarly, purchasers may place “special” value on the business, often resulting from additional strategic benefit or synergies they can extract from the business given their current situation.

The market value of a business is usually within a range from the base value as calculated and a higher amount purchasers are prepared to pay.

Other attributes of the business

Other factors include age of the business, techological obsolescence and the quality and length of the lease on the premises if location is critical to the business.

The purchaser is focussing on past performance to determine price, but is focussing on expected future performance to determine value.

Business Systems Analysis

Business Systems Analysis is a method of evaluating those other issues. This model covers key strategic issues in a business as follows:

Product Design and Development

  • Product attributes
  • Quality
  • Time to market
  • Proprietary technology


  • Access to sources
  • Costs
  • Outsourcing


  • Costs
  • Cycle time
  • Quality


  • Pricing
  • Advertising/Promotion
  • Packaging
  • Brands

Sales and Distribution

  • Sales effectiveness
  • Costs
  • Channels
  • Transportation

 A more sophisticated method

A more sophisticated valuation method is useful for larger businesses. Continuing Value of the business is another method of estimating value based on the present value of expected future cash flow over a specified period.

References for further reading

VALUATION – Measuring and Managing the Value of Companies, Second Edition.Tom Copeland,Tim Koller,Jack Murrin, McKinsey & Company, Inc. ISBN0-471-08627-4
Business Valuations Digest Centre for Professional Development

Pricing a business with inconsistent earnings

Pricing a business with inconsistent earnings

If you own a business that has been GFC affected and still want to sell (or are advising someone in this position), there are ways to proceed sooner rather than later.

Market value of a business is linked directly to its free cash flow. The normal benchmark for value is a required rate of return (capitalisation rate) applied to Future Maintainable Earnings (FME). Fluctuating historic and projected earnings make it more difficult to determine the underlying level of FME. In addition, greater than usual fluctuations can increase the perceived risk, and may prompt requirement for a higher capitalisation rate, the reciprocal of which is a lower earnings multiplier.

The overall effect may be a reduction in assessed value, even if the true underlying earnings have returned to ‘normal’ levels.

The GFC has affected the majority of industries to some degree, whether it be lower volumes, tighter margins or bad debts. These may have impacted on profit trends and made assessments more varied. Recent floods and the subsequent rebuilding are expected to further affect forecasts.

If a business has $1M EBIT for two years, then zero profit for the next year followed by YTD results showing a return towards historic levels – an average of earnings incorporating the depressed year’s results yields a distorted estimate of future earnings.

Whilst it may be justifiable to exclude unusually high or low historic results from the assessment where a return to ‘normal’ earnings is evident thereafter, if the unusual results are in the most recent full-year it does not automatically follow that the subsequent year will return to the historic ‘norm’. Markets change, complete recoveries are not assured and new baselines are not always easy to plot.

In this situation, it is important to provide detailed and substantiated forecasts of the current full year’s results. Such an assessment takes into account current Year to Date (YTD) trading results, plus projected results for the remainder of the period. Substantiation would include actual orders in hand and anticipated forthcoming work.


What are the options?
The business owner has some options, including the more obvious ones:

  • Wait for the market and profits to stabilise, and establish a new consistent track record. The downside is that this strategy may take several years and the result is not assured.
  • Prepare a full year’s trading report for a more current period, say 12 months to February 2012.
  • Sell at a discount. Not everyone wants or needs to maximise the sale price outcome, and other considerations may take priority;

With some creativity and expertise, it is possible to structure an agreement that can deliver the true value of the business and crystallise a sale sooner. A structured price model with some of the proceeds paid on settlement according to baseline recent performance, with provision for further payments as profit milestones are reached. If the owner is confident that the worst is behind the business, then it may be in everyone’s best interest to share the risk and responsibility to manage the business through to smoother waters.

It is always preferable to have a clean transaction without strings attached. However, provided the up-front component is sufficient to allow the seller to proceed and further payments are considered a bonus, then the ultimate result could work well for a retiring business owner.

Your accountant or a Divest Merge Acquire advisor can provide more information regarding these options.