If you’re planning to sell your business, bring on an investor, form a partnership or give a key employee a stake, you’ll need to calculate what your business is worth.
This can be tricky for small businesses, because – unlike listed companies – there’s no share price determined by market forces.
Below are three commonly used methods to value a small business. In many cases, it may be helpful to use more than one method to get a more accurate picture.
Turnover-based valuation
This method, often called the times revenue method, involves multiplying your revenue by a specific number.
It’s commonly used for service or professional businesses where most expenses are discretionary – that is, controlled by the owner and not essential for basic operations.
A general rule of thumb is to value a business at between three and six months’ turnover. To account for seasonality, use the average turnover, meaning six months’ turnover would be your annual turnover divided by two, not the turnover for a specific six-month window.
While this method is simple and quick to apply, it doesn’t account for profitability, so it’s usually best used in combination with another valuation method.
Asset-based valuation
This approach is often used when someone wants to buy only the business’s assets, not the business as a going concern.
There are several ways to calculate asset value:
- Using the net asset value listed on the business’s balance sheet
- Estimating the market value of its net assets
- Considering only the assets (and excluding liabilities), particularly when the liabilities are secured
- over the owner’s personal assets and would be repaid from the sale proceeds
This method is often suitable for businesses with significant tangible assets – such as machinery, vehicles or real estate – and may not reflect the true value of businesses that are heavily reliant on goodwill or intangible assets like brand reputation or intellectual property.
Earnings-based valuation
These methods are typically used for larger businesses or those in manufacturing or retail, where consistent earnings data is available.
Options include:
- Estimating how much an investor would need to invest today at current interest rates to generate earnings equivalent to those produced by the business
- The discounted cash flow method, which projects future earnings and adjusts them for inflation
- Return on investment calculations (e.g. if a business earns $10,000 per annum and an investor wants a 5% return, they’d be willing to pay up to $200,000)
The outcome will depend on:
- The expected rate of return or interest rate
- The number of years used in the calculation
- Inflation (if factored into the formula)
To determine a business’s underlying earnings, you start with its net profit and add back certain items to calculate EBITDA – earnings before interest, tax, depreciation and amortisation. Add-backs may include:
- Abnormal or one-off items, such as gains on asset sales
- Depreciation, since this is considered in asset valuations
- Interest and amortisation, which vary based on ownership structure
- Tax, which is influenced by the above adjustments
Small businesses may also add back owner-specific expenses, including:
- Discretionary spending that’s not essential to operations
- Owner salaries (if the owner isn’t remaining in the business), which are often based on business performance rather than market benchmarks
This method offers a more accurate reflection of a business’s earning potential and is popular among serious investors or buyers.
Combining valuation methods
You can blend the above methods for a more holistic valuation. For example, you might use an earnings- or turnover-based method to calculate goodwill, such as brand value or client relationships, and then add the value of the tangible assets using the asset-based approach.
This layered strategy often provides a more realistic picture, especially for businesses with both significant assets and strong earnings.
Valuing a business involves many assumptions and variables, so it’s not a one-size-fits-all approach. For an accurate valuation tailored to your specific circumstances, speak to a qualified accountant.
