The Main Methods for Valuations

Appraisals are not Valuations
Always remember that an appraisal is not a valuation. An appraisal is not a professional valuation. It is an assessment or opinion by a broker or agent who deals in that type of business, with the experience of past sales. They will take into account what the market is saying and their price will reflect their experience handling businesses in that type of industry.

Main Aspects for Consideration in Valuation
There are 3 main considerations to look at.

These are:

  1. Capitalisation of Profits.
  2. A value which is based on the dividend yield.
  3. An asset value.

These can be complex calculations, so professional advice is advised in these areas.

2 Basic Methods of Valuation
There are 2 basic methods used in determining the value of a business:

  1. First Method - Expectation of future profits: This is based on the expectation of future profits and the return to the buyer for his/her investment. Many prefer this method because it forces the buyer, as well as the seller, to focus on sales and profits, to arrive at the capitalisation value of the business. There is also an expectancy of what the return on investment will be.

  2. Second Method - Value of assets and goodwill: This is based on the value of the assets at the time of the negotiations, plus the goodwill, for the potential worth of the business. This method gives little consideration to the future of the business because it is based on the asset value relating to the business at that present time. It is not commonly used because it is not reliable.

1. First Method - Expectation of Future Profits
This method is also known as "Capitalisation of Profits" method. To arrive at a valuation using this method, financial statements and their meanings are analysed. Before you proceed with valuing the business in this manner you should fully assess the past performance, as well as the future potential, of the business.

To do this, consider the following points:

  • The trading results of the business for previous years.
  • Whether the results stem from any weaknesses of the owners or is attributable to the business itself
  • Check whether there are any agreements in place that could affect the future of the business.
  • Check whether there are any legal restrictions on the business.
  • Examine the likely future performance of the business and conclude whether there is potential growth or potential decline.

Once you have answered these points, you can consider whether you will purchase the company, or whether you will just purchase the assets and liabilities of the business.

a) Components Involved
Valuing the profits in this manner is a solution to the problem of how to arrive at a proper value for a business. If you look at the business as an investment, its true value should be established by calculating expected profits from that investment.

The following points outline how to value a business by capitalising the net profit.

Every investment has 3 components:

  1. The dollar amount invested.
  2. The dollars returned from the investment.
  3. The return expressed as an interest rate received on the investment.

When purchasing the business you need to calculate what the investment value (i.e. the price) should be.

If you use the equation of: Investment x Interest Rate = Return

You will be able to calculate the maximum total price that the business is worth to you (as an investor).

You will also need to know:

  • The annual dollar return figure.
  • What interest rate you would expect on your investment.

b) 5 Stages of the Process
The valuation process for method one can be summarised in the following stages:

  • Stage 1 Work out a reliable estimate of future sales.
  • Stage 2 Calculate the costs and expenses for the future.
  • Stage 3 Work out the resulting forecast on net profit before interest and tax.
  • Stage 4 Work out the required rate of return that you will be looking for.
  • Stage 5 Calculate the value of the business by using the equation above to capitalise the expected future net profit before income tax.