How to avoid the most common error with business valuations

A commonly made mistake when valuing a business is taking the approach to valuations the wrong way around.  Being aware of this and knowing the right way to go will improve the accuracy of your advice to your clients.

The issue arises from the attempt to value goodwill of the business separately from the assets.

At first glance this statement could sound a bit illogical. Isn’t that what needs to be done?

Establish the value of goodwill in order to establish the value of the business as a going concern? The answer is a big NO.

The only way to calculate the value of goodwill is exactly the opposite.

Where the standard for a valuation is ‘fair market value’ then the valuer needs to calculate the value of the business as a going concern first.  Meaning market value of the enterprise taking into consideration and including tangible assets, goodwill, working capital, stock and any other components and then work backwards to arrive at the value of goodwill.

The reason for this is that the value of the business is driven and dictated by the market and market forces. Buyers on the open market calculate value of the business based upon enterprise value. This means total investment necessary for acquisition. To understand this in a bit more detail lets look at the following hypothetical example.

Example;

At the same time there are two competing business for sale on the market. The two businesses are very similar except that the value of the assets in one is larger than the value of the assets in the other.

Business 1:

Returns a profit of $100K EBITDA  (P) and has plant and equipment value of $250K (A)

Business 2: 

Returns a profit of $100K EBITDA (P) and has plant and equipment value of $100K (A)

A willing buyer is looking for a return on his capital of 25% (I) 

So the formula for calculating value from a buyers point is P/I=Value

The formula for calculating goodwill will be Value – A

Business 1:

Value = $100K/25% = $400K

Goodwill = $400K – $250K = $150K

Business 2:

Value = $100K/25% = $400K

Goodwill = $400K – $100K = $300K

In both cases the value of the business is the same but the goodwill value in example 1 is $150K compared to example 2 of $300K. That is 100% higher in business number 2!

Due to this, in the two examples above, if the value is calculated differently by calculating the value of the goodwill, which would be the same,  then adding assets on top of it, the business value will be different by $150K. This is a 25% higher valuation for business 2 than business 1 that real buyers would price identically.

The value of the physical assets don’t necessarily have an impact on business operations and business value. The value of the business assets could be different due to management decisions, market forces at the time of purchase of those assets etc. Businesses can be over or under capitalised but this does not increase or decrease the value of the business.

In real life the error is made even bigger due to inexperienced valuers adding the value of the inventory on to their calculation and ignoring working capital completely which buyers include in calculating their total investment.

Larger the asset component, the larger the potential error.

Further more the most common method used for this incorrect calculation of goodwill is the capitalisation rate method. Most valuations that I have seen done this way usually don’t have a strong case for the rate used for the calculation which makes the valuation even more inaccurate.

The value of the goodwill in fact has nothing to do with the value of the business. It is actually a  derivative of business value.

Zoran Sarabaca

Registered business valuer, Principle of Xcllusive.

15 years experience in sales and valuation experience.

Xcllusive Business Sales provide business sales and valuation services Australia wide for SME’s up to $10million in value.
Call today for more information 1800 VALUE 1 (1800 825 831)
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