The methodology outlined below is a simplified approach and as purchasing a business is a very significant step and every individual's circumstances are different, I strongly recommend that you speak with a professional advisor familiar with your personal situation and needs before entering into any binding contract.
VALUING A BUSINESS: CRITICAL POINTS
There is no right or wrong amount - There is only what you are prepared to pay and what the seller is prepared to accept - nothing else is relevant.
How much to pay is based on what CASH you can realistically expect to generate from the business in future years - (There are many valuation methods available from complicated mathematical formulas to a simple percentage of sales. These methods make a good cross-check to the method suggested below).
HOW MUCH TO PAY - THE METHODOLOGY
STEP 1: NORMALISED PROFIT
Calculate a "normalised" annual cash profit (before tax) the business is likely to earn next year based on its past history. This is usually done by beginning with Last Year's annual profit and making adjustments for items
incurred last year but won't be incurred next year
to be incurred next year but weren't incurred last year
Non-cash items
Examples of items you could adjust for
INCREASE PROFIT BY
Any wages or benefits paid to the business owner (or people related to the business owner) who will not be continuing when you own the business. This is not just wages but superannuation, medical benefits, motor vehicles, non-business (or slightly business) travel etc.
Interest Paid and any Other Finance Costs (that you will not be responsible for)
Depreciation and any other Non-Cash Items
Any Non-recurring expenses that occurred in the prior year (e.g. legal fees on a case which is now resolved)
The expected annual profit of any new (major) customers not included in the past year's sales
DECREASE PROFIT BY
The market wage & benefits payable to you and any partner/relation that will work in the business (the amount is what you would be paid if the business was owned by a 3rd party and not necessarily what you will actually be paid)
Any expenses that will be incurred in future years, which are not included in last years' profit (e.g. the business moved premises 3 months ago into a more expensive site - decrease the profit to reflect the new rental for the next 12 months less what was paid last year)
Any revenue earned last year that would be considered abnormal or not likely to occur next year (e.g. a large client was lost to a competitor, a "special" job which won't occur again)
If there is likely to be significant capital expenditure (new equipment) over the next 3 to 4 years then an adjustment should be made (usually the cost of the equipment divided by the estimated years it will be used in the business)
At the completion of this stage we will have a value which represents the NORMALISED CASH PROFIT. This is the amount of profit before income tax that the business is expected to earn next year if it continued to run as it has done in the past.
STEP 2: SELECT AN APPROPRIATE MULTIPLE
There have been books written on what multiple to select and why, but here's a RULE OF THUMB which has served me well through many purchases. There are 2 ranges
Smaller Business (Profit less than $100,000) 2 to 3
Medium Business (Profit $100,000 to $500,000) 3 to 4
(This methodology is not suitable for larger businesses)
STEP 3: CALCULATE THE VALUATION RANGE
Multiply the NORMALISED PROFIT calculated in Step 1 with the MULTIPLES in Step 2.
E.g. If you had a normalised profit of $150,000, the valuation range would be $450,000 to $600,000
STEP 4: NARROW THE VALUATION RANGE
To narrow the range further compile a list of factors which either improve or detract from the certainty that you will earn the normalised profit amount calculated in Step 1. Each factor that improves the certainty will support paying a higher amount in the range, each factor that detracts from the certainty supports paying a lower amount in the range. Based upon the number and importance of the factors in each category will allow you to tighten the range to either the lower, middle or upper portion of the range calculated above.
Examples of factors include
1. Age of Business
A business that has existed for 20 years is likely to have more certain earnings and be more established in a market than a business that has existed for 2 years
2. Size of Business
Generally the larger the business the more likely the business would survive any negative events
3. Certainty of Revenue Stream
There are many items that might improve or detract from revenue including