How to Calculate the Value of Business Based on Profit

How to Calculate the Value of Business Based on Profit

The value of your business is a key factor especially when it comes to selling it. Any potential buyer would want to know how much the business is worth before committing.

Reasons to value a business

Determining the value of a business is an essential exercise, one that gives businesses a strategic advantage. With that said, let’s look at the top reasons for business valuation. 

Planning exit strategy

This is one of the major reasons why most people value their businesses. When planning to sell a business, it’s important to determine its value, as this helps to improve the profitability of the business, so as to increase its value when selling. Also, it ensures that you have the right information about the fair market value of the business, which prevents capital loss because of inaccuracies or lack of clarity. 

When buying or selling a business

Although buyers and sellers have different opinions on the value of a business, the real value of a business is the offer that the seller and buyer have agreed on. So, business valuation considers profitability, marketing conditions, and other issues to ensure the viability of the business. 

Strategic planning

Knowing the current value of your business gives you the information that you need to help you make better strategic decisions for your business. 

Selling business shares

The right business valuation allows business owners to know the value of their shares, which prepares them in case they want to sell the shares. 

Valuing a business involves a lot of variables and it can be a hard task. There are several methods of valuing a business, one of them being the profit multiplier. This valuing method uses the company’s earnings as the basis for determining value. It is quite viable as it informs the owner how much income he or she can expect from the business. Before we get into how to calculate the business value based on profit, let’s define profit.

Definition of Profit

Profit is the financial benefit gained when a firm gains more revenue than expenses. Such expenses include taxes and other costs incurred during its activities. It measures the degree to which a business makes money. The profit then funnels back into the business. It is either taken by the business owner or reinvested back to the business. In simple terms, profit is the total revenue minus the total expenses.

In the case of a business on sale, you calculate the business profit differently. This is because the new owner will not take up all the previous owner’s expenses once they buy the business. An example of an expense the new owner will not take up is a business loan interest expense. You will thus exclude such when calculating the profits for business valuation.

According to Orlando Business Broker, another thing to consider before valuation for sale is the income of the business. If there is a variable that brings in some income courtesy of the present owner, adjust it to account for such. For example, in the case of a hair salon, there could be a hairstyle bringing in sales. If only the owner knows how to make it, consider it during profit calculation.

Profit Multiple-Valuation

When using the profit multiple-valuation, you can work with two figures. These are the annual profit for the business, and the standards applied to firms in the same industry.

Annual profit multiplier

For the annual profits, you can consider the profit of the company over a radical period like five years. If you use the profits over the past year, the estimate will not be quite reliable. For instance, if the business incurred a loss or earned a small profit, the value will be quite low. Also, if the business earns a very high profit, the value will be higher than usual. Neither is reliable as it gives the buyer a value that is not coherent with the true value.

Industry multiplier

This is the figure that business owners in the same industry use to value their businesses. For instance, if the figure for your business industry is two, you multiply the business profit by two. The result is the value of your business. The number can vary from year to year depending on the changes in the industry variables.

Other variables to consider during business valuation using the profit multiplier method are;

Value-enhancing variables

The profit of your business is not enough for determining the value of the business. Thus, it is key to adjust the sales of your business to show the value-enhancing variables. For instance, the business can have a long-term lease at a favorable locale with great terms. This is part of value-enhancing variables. It enhances sales and reduces the cost that the business would have incurred over time. Thus, the annual profit alone cannot give you the correct value of such a business.

Value-detracting variables

You should also adjust the business value if there are value-detracting variables. For instance, if the workers have no rest time, or no motivation to work, they may end up being unproductive. With time, this affects the business sales, and by consequence, the business value. You should consider such a factor when valuing the business