"Businesses are as unique and complex as the people who run them and are not capable of being valued by a simplistic rule of thumb."

It surprises many owners to learn that business value is relative, not fixed. It can vary based on the reason for transferring ownership and on the conditions under which a transfer is made.

For example, the business value for a third-party sale may be significantly higher than that established for a transfer of the same business to key employees over time, or a "gift" of the business to children.

These "rules of thumb" are all well and good, however they are gross simplifications and should only provide a general idea of a suitable price range for a particular business.

Here's a quick list of some of the "rules of thumb" methodologies commonly used for valuing businesses

1.  Asset Valuation

This is used by businesses with predominantly physical assets, especially inventory.

The valuation takes into account ...

(a) the fair market value of fixed assets and equipment;

(b) the value of leasehold improvements;

(c) inventory.

2.  Capitalization of Income Valuation

This is used by businesses with predominantly intangible assets.

It places no value on physical assets, only intangibles.  Typically used by service businesses.  Under this method, various factors are given a weighting and the average of these factors yields the "capitalization rate" to arrive at the market value of the business.  

3.  Capitalized Earnings

This method is based on the rate of return anticipated by the investor.  SME's are expected to have a rate of return of 20-25%.  So, if your SME has expected earnings of $1,000,000 for the year, its value may be $4,000,000 - $5,000,000.

4.  Cash Flow

This method is simply based on how much of a loan the purchaser could get based on the adjusted cash flow of the business.  The adjustments to cash flow are for amortization, depreciation and equipment replacement.  Obviously, when using this method, the value of the business fluctuates with changing interest rates.

5.  Discounted Cash Flow

This method discounts the business's projected earnings to adjust for real growth, inflation and risk.  It calculates the value today (i.e., discounted for time) of the business's future earnings.

6. Tangible Assets (Balance Sheet)

This method is basically a value of the business's current assets and nothing else.  Typically used where the business is losing money. This approach will usually be utilized when selling the business is just a matter of getting the best possible price for the equipment, inventory and other assets of the business.  A good strategy is to approach other firms in the same business that would have a direct use for such assets.

7.  Multiple of Earnings

A multiple of the cash flow of the business is used to calculate its value.

However, determining an earnings multiplier can be difficult, and the following 5 points need to be considered.

1. Examine the most recent year's earnings on the seller's latest tax return.

2. Look at the tangible and intangible assets.

3. There is real estate involved but it is not for sale.

4. Does the owner have salary, perks, and certain one-time expenses.

5. Are there any cash allowances for depreciation / amortization expenses

Once you have calculated projected annual future earnings, also known as EBIT (Earnings Before Interest and Taxes), consider the risks involved in owning the business. How much are you willing to pay for the business given the risks involved? The right earnings multiple really depends. For most businesses, it's somewhere between 3 to 5 times EBIT. But, the multiple is less when there are few tangible assets and more when the business is uniquely attractive.

There is no sure fire valuation method.

The true value is the perceived value to a buyer who is ready, willing, and able to buy it.

The most common method is the earnings multiple. The right multiple is, in the eyes of buyers, a matter of assumed risk. Buyers feel better about buying tangible assets that they can appreciate with their five senses - things like real estate and equipment. On the other hand, buyers are also enticed when there is a clearly attractive opportunity to make money, regardless of the tangible assets included.

The take away from all of this is regardless of what someone comes up with using any of the above methods the equation below is the key driver of the outcome.

Valuation = Risk / Return