What Is The Simplest Way To Value A Business?

There are two possible reasons why you want to know the simplest way to value a business, which are that you are looking to sell your current business or you are looking to buy a business.

In either case the same principles apply, but what I've found in most cases is that owners who sell businesses tend to focus on potential value into the future vs business buyers tend to focus on historical information.

When you think historical information doesn't lie, this makes sense, but it can leave a gap between the two values.

Where I see this in the extreme is on programs like Dragon's Den, where entrepreneurs come on to the show and often seek an investment from the Dragons that values their business at ridiculous levels.

Entrepreneurs often use future revenues to value their business as it stands, but the Dragons want to value the business based on what it has done to this point in time.

That being said, at the end of the day the true value of a business is where a willing seller and a willing buyer agree a price.

But there has to be a starting point for both sides, and with that in mind let's look at the simplest way to value a business.

The simplest way to value a business is to multiply the profits of a business by a profit multiple. The profits of the business need to be adjusted for costs and income that won't apply after the business is sold, and the profit multiple is affected by a number of characteristics of the business.

What business profits are used to value a business?

The business profits used to value a business will be those disclosed in the financial statements for the business, as adjusted for expenses and income that will not be taken over by the new owner.

Whilst this seems straight forward on the face, different people use a different profit figure to value a business. There are two main profits used by different people, which are EDITDA and EBIT, which are explained as follows:

1. EBITDA - Earnings before interest, tax, depreciation and amortisation. In other words, you take the pre-tax profit shown on the profit and loss statement and add back interest, depreciation and amortisation.
2. EBIT - Earnings before interest and tax. In other words, you take the pre-tax profit shown on the profit and loss statement and add back interest.

In my opinion you should be using EBIT, as depreciation and amortisation are 'real' costs of a business, especially depreciation. Depreciation is a charge that represents the cost to the profit and loss of the fixed assets owned by the business.

These include plant and machinery, vehicles and furniture and fittings. Bearing in mind all assets will need to be replaced at some point in the future.

If you use EBITDA to value a business, you would be over-paying for the business.

It makes no sense to add back depreciation and amortisation, as the business needs profits to provide money to pay for assets in the future, so if you ignore depreciation or amortisation, you are ignoring the fact that the business needs to replace its assets too.

Warren Buffett puts it like this: “Does management think the tooth fairy pays for capital expenditures?”

Where this difference between these two valuation methods becomes more pronounced is when you have a business that has a lot of fixed assets and where depreciation is a large cost to the profit and loss.

I found this out when I looked to buy a transport business which had some expensive vehicles, i.e. lorries, on the balance sheet. If I had ignored depreciation or added it back, this business would have been over-valued by a very large amount.

In fact I found this business through a business broker who had helped the owner value the business using EBITDA, which created a high expectation from the owner for a higher price for the business.

How is profit multiple calculated?

The profit multiple for any business is probably one the most subjective number of any business valuation.

The multiple itself can range from one-times to say 25-times multiple, and anything in-between, which doesn't makes it exactly easy or simple to value a business, especially if you are new to the whole process.

But that doesn't help you if you are reading this article hoping to go away and calculate the value of a business. So let me give a few pointers to help you with this process. These pointers are factors that will impact on the multiple, and on the ultimate value of the business.