6e) Return on Investment/Capital For a return on investment value, we are assuming that no fixed price has been given for the business and therefore you will use the net profit and your proposed return on investment percentage to determine a price. For example, a business makes a net profit of £20,000 and you expect an investment return of 10%. In which case, £20,000 divided by 10% gives a value of £200,000. A return on capital approach would assume that a fixed price has been given for the business in which you can use to determine whether it is a wise investment. It may be that your money is worth investing elsewhere such as a bank that offers an average return of around 5%. Using basic terms, let’s say the business is for sale at £100,000 and the net profit is £10,000. To find the return rate, you would divide the net profit by the business price and then work it out as a percentage: (see below) £10,000 divide by £100,000 = 0.1
0.1 x 100% = 10% Return on Capital Employed
With a 10% Return on Capital Employed, It would therefore be a good investment as the rate is higher than that of the bank. Should the rate be unacceptable, you would use the return on investment method to determine a more suitable price in order to give you your desired return.
6f) Capitalization of Income Value
This method is used more commonly for services and therefore considers the intangible value of the business. Such businesses are usually contract orientated and consequently you can fall into high risk situations. It would further be wise to use an accountant to determine that the business would have a favourable outcome should it suffer from a change of ownership.
This method involves using factors to determine an average figure called the “capitalization rate”, say, between 1 (low) and 5 (high) to multiply against the owner’s discretionary income (profits, owner's salary, non essential expenses etc) the following list has a low score potential of 11, and a high of 55. Such factors will include:
Profitability (concentrate on future, not past, profitability) Competition (present and future) Customer base, particularly those under contract Full risk analysis Your suitability (your standard of experience and knowledge in the industry) Future potential for the industry Why the present owner is selling How long the business has traded How many past owners Location of business to customers Where growth lies within the business
If after rating the above as, say, 20 and the discretionary income is £20,000, the sum would be:
20 x 20,000 = £200,000 purchase price As these factors are very subjective, it could be difficult to agree an exact “capitalization rate” and therefore an alternative valuation method should be adopted if you are too far from the sellers rate. 6g) Owner Benefit Valuation This method uses a figure between 2 and 3 (depending on what you think is appropriate) and multiplied by the owner’s discretionary cash-flow. Discretionary annual cash-flow can be referred to as the money that is not used in the operations of the business - profits, owner's salary, non essential expenses etc. Using this approach gives a value that reflects the business’ ability to generating cash-flow and profits. If you want, say, 2.5 times the owners total benefits and the discretionary income is £20,000, the sum would be: 2.5 x 20,000 = £50,000 purchase price |
