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Business Valuations – How Much Is Your Business Worth? (Part 2 of 2)

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(Continued… part 2 of 2)

 

2. Earning Value Approaches

These business valuation methods are predicated on the idea that a business’s true value lies in its ability to produce wealth in the future.

The most common earning value approach is Capitalizing Past Earning.

With this approach, a valuator determines an expected level of cash flow for the company using a company’s record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor.

The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.

Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.

 

What might such capitalization rates be?

As a general guide :

Well established businesses with a history of strong earnings and good market share might often trade with a capitalization rate of, say 12% to 20%.

Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalization rates, say 25% to 50%.

Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty is directly tied to the identity of the business owner. Whether the business involves plumbing or management consulting, will existing customers automatically expect that a new owner delivers the same degree of service and professionalism?

Any valuation of a service oriented sole proprietorship needs to involve an estimate of the percentage of business that might be lost under a change of ownership.

Note that this can be mitigated in many cases, such as when a trusted family member (who may already be familiar with the client list) takes over the business.

 

3. Revenue Method

This is common in a professional service firm with recurring income from loyal customers.

For eg, Audit Firms, Accounting firms, Payroll Services firms, Corporate Secretarial firms.

 

4. Market Value Approaches

Market value approaches to business valuation attempt to establish the value of your business by comparing your business to similar businesses that have recently sold.

Obviously, this method is only going to work well if there are a sufficient number of similar businesses to compare.

Assigning a value to a sole proprietorship based on market value is particularly difficult.

By definition, sole proprietorships are individually owned so attempting to find public information on prior sales of like businesses is not an easy task.

 

Conclusion :

1. Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price.

2. The final valuation would very much depend if the price is set from Buyer’s or Seller’s perspective.

Hope the above helps

If you need help, feel free to contact us at :

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www.corporatebackoffice.com.sg

 

Written by Kelvin Loh