How Much To Pay For A Business ?

When a seller quotes a price for his business it is known as “Ask price”. In response a buyer offers his price; this is known as “Bid Price”. After negotiation both parties agree at a price to close the deal. In order to make a bid price a buyer must do a valuation of the business he is interested in. There are five methods of valuing a business before buying it:

1. Asset Value: This is the easiest method in valuing a business. Underlying assumption in this method is that the business is a going concern. You tally all assets tangible and intangibles, fixed and current to get the total value. In the case of fixed assets either you can take the value net of associated depreciation or on replacement value basis. Current assets are appraised generally on realizable amount basis. Intangibles such as goodwill can be re-estimated. From the total assets value you must deduct outside liabilities to arrive at net value of assets in a business. Although the method is a popular one, it lacks credence as it does not take the capacity of the assets to generate income in the future, which is more meaningful to the buyer than just jotting up assets. Moreover, small businesses as well as service providers are very lean on assets but fat on earnings. Hence, asset value may not be representative for these businesses. On the other side of the coin, large scale industry is asset rich but whether they generate adequate returns on assets employed is a moot point.

2. Liquidation Value: In contrast to the asset value which is based on going concern, liquidation value takes the business on the footing that it is a gone concern. Liquidation can take place in two ways: orderly or forced. An orderly liquidation takes time and the value cannot be estimated in a brush stroke. Forced sale can take place in near term and it is possible to tug in on likely price. Whichever the manner of disposal, you should ensure that the assets are valued at realizable value net of any expenses connected thereto

3. Earnings Multiple: Since buyers are more concerned with what they can get from using assets, earnings multiple as a method of valuation is used widely in business buying transactions. Generally after tax earnings is considered as the bench mark figure in this type of valuation. You take 3 to 4 years of after tax revenue and average it. Thereafter, you can multiply the figure with number of years purchase. If the average after tax earnings is Rs 1,00,00,000/- and the multiple you are conceding is 5 times then the bid price is parked at Rs 5,00,00,000/- Earnings multiple method suits well in retailing, wholesaling and medium to large businesses. It is important that you use earnings multiple where the existing business is low geared, that is, it does not use much of borrowed funds. Additionally, you must ensure that depreciation charge in the business is not heavily loaded. A litmus test to opt for this method is to compare the cash-flow with earnings-flow. If there is no substantial difference between these you can choose earnings multiple; otherwise select capitalizing cash-flow method discussed below

4. Capitalizing Cash-flow: Cash-flow is different from earnings in that it ignores accrual accounting concept and non-cash expenditure. It pitches straight on rendering of inflow, outflow and the resulting net flow. Your net cash-flow is what remains in your hands when everything was said and done. There are two ways of arriving at cash-flow for valuation purposes:

4.1. Net-flow + Depreciation
4.2 Net-flow + Interest + Tax + Depreciation (Alternatively known as “EBIT+D” which means Earnings before interest, tax and depreciation)

Once you arrive at a figure under any of the above two methods, you can capitalize cash-flow by using a capitalization ratio chosen by you. Let us assume that, the cash-flow is Rs 15,00,000/- capitalization rate is 20 % then you can work out the business value as:

Rs 15,00,000 divide by 20 and multiply by 100 equal to Rs 75,00,000/-

5. Market Value: Alternatively known as Rule of Thumb or Comparable Business, this method focuses on the market and how it responds to the value proposition of a particular business. You can determine market value in a number of ways. One way is to find out the sum in which similar business was sold and take that as the market value. Another method is to search in the business press for similar transaction that took place during the last 3 months. Yet another method is to estimate the amount the market can bear and after making suitable adjustments treat that as bid price

You can use these methods whether you are buying the whole or part of a business and by extension shares.

About Keerthika Singaravel

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