Most business people expect that an established business is worth more than its asset base. This extra value is known as business goodwill.

In other words, you can determine your business value as the sum of its assets plus business goodwill.

The accepted way to estimate the value of business goodwill is to capitalize the so-called excess business earnings. You can use the well-known Capitalized Excess Earnings business valuation method, sometimes called the US Treasury method to do the job.

Business value = Assets + Business Goodwill

Once you determine the fair market value of business assets, you can calculate the value of business goodwill as follows:

• Start with business earnings, usually net cash flow.
• Subtract a fair return on business net tangible assets. The difference is the excess business earnings.
• Capitalize the excess earnings to calculate the value of business goodwill.

Business goodwill value: positive or negative?

The value of business goodwill you get from above is positive for most established businesses. Occasionally, a business goodwill result can be negative. What can this mean?

• Business earnings are below the fair return on business assets.
• Some business assets are not fully used to generate income.
• The business is seen as high risk which calls for a high rate of return on business assets.

Handling negative business goodwill

If you get negative business goodwill value, consider these points:

• Make sure you account for all business earnings correctly. See how net cash flow is calculated.
• Identify which assets are either overvalued or not fully used to produce these earnings. Adjust the asset values.
• Revisit your fair rate of return figure. See how to build it up to properly capture your business risk.

One of the benefits of using asset based business valuation methods is that you can see how each business asset and liability contributes to business value. This is very useful for a number of important reasons:

• Estimation of business value for tax purposes. 
• Business purchase price allocation.
• Determination of which business assets are available as part of business sale.

To use the well-known asset accumulation method to value your business, you start with the current balance sheet. You then adjust this cost-basis data, accounting for off-balance sheet items and estimating the fair market values of business assets and liabilities. The difference is business value.

One of the important adjustments is determining the value of business long-term liabilities. A typical example is a commercial bank loan. Business management may have negotiationed the terms of such financing some time in the past. As financial market conditions change, so do the terms of such loans.

So how can the terms of debt financing obtained awhile ago affect what your business is worth today? Let’s take a look at an example.

Example: favorable financing and business value

Suppose that you have a commercial bank loan with $250,000 balance and a 10 year term at an attractive 4.75% fixed annual interest. Under this arrangement your yearly payment, including both principal and interest, is $31,454.32.

If you were to raise this loan today, your bank would charge you around 7.75% interest. This would mean an annual payment of $36,003.19. By financing debt at the lower 4.75% rate, your business saves $4,548.87 each year.

This effectively lowers the present value of the loan. And since your business value is calculated as the difference between the present values of the business assets and its liabilities, such favorably financed debt works to increase your business worth. 

You can account for this business value-enhancing effect of lower cost debt financing as follows:

1. Start with your current annual payment of $31,454.32.
2. Discount this payment stream at the current market rate of 7.75%.
3. Calculate the present value of the debt. This is what the favorably financed loan is worth today.
4. Subtract this amount from the fair market value of business assets.

Using ValuAdder Loan Schedule and Discounted Cash Flow calculations you find that, instead of $250,000, the commercial loan is worth only $213,461.86 today. Other things being equal, this contributes $36,538.14 to your business value.

As the name implies, the income-based business valuation methods consider business earnings when calculating business value.

Importantly, the direct capitalization methods, such as the well-known Multiple of Discretionary Earnings method, use a single number as its earnings input.  Coupled with a matching choice of capitalization rate, which captures business risk, the Multiple of Discretionary Earnings method produces very accurate business valuation results.

A big advantage of this method is that it automatically matches your business earnings and the capitalization rate – a key requirement for accurate business valuation.

Multiple of Discretionary Earnings uses seller’s discretionary cash flow as its earnings basis and lets you specify business risk based on a number of essential financial and operational business performance factors.

So how do you choose the business earnings number? There are several choices to consider:

• Simple average of SDCF taken over several years.
• Weighted average SDCF value.
• Squared weighted average SDCF value.

Your choice depends on which way of calculating business earnings best represents the business income prospects going forward.

For example, if the earnings don’t change much year over year, a simple average of SDCF over the last 3 – 5 years is a good choice.

On the other hand, the weighted average and, to a greater extent, squared weighted average schemes put stronger emphasis on the most recent business financial performance. These choices are best if your business earnings changed significantly in the last few years.

A custom weighting scheme may be good if you want to handle unusual years - those showing business earnings that are either much higher or lower than normal.

Example

Let’s say that you need to value a business with the following seller’s discretionary cash flow history over the last 3 years:

1. Year 1 (earliest): $100,000
2. Year 2: $135,000
3. Year 3: (most recent): $159,000

Based on your analysis, the business shows average performance across all 14 financial and operational performance areas considered by the Multiple of Discretionary Earnings business valuation method. Given this, you decide that, on a scale of 0 – 4.0,  the business gets a rank of 2.5 in each area.

Business net working capital is $50,000; and it has no long-term debt. Business leases its premises and, in your judgement, carries no excess assets.

Scenario 1: Business valuation result using the simple average to calculate the earnings basis

In this case, your business earnings are just the sum of the 3 annual values divided by 3:

($100,000 + $135,000 + $159,000) / 3 = $131,333.

Using this value along with the $50,000 for the business net working capital and setting all performance weights to 2.5 produces the following business valuation results:

Business Value = $378,333.

Scenario 2: Business valuation result using the squared weighted average to calculate the earnings basis

This time, you decide that business earnings in the more recent past are better indicators of what the business will likely earn in the future. You select the weights of 1, 2 and 3, square them, and calculate your earnings input as follows:

($100,000 x 1 + $135,000 x 4 + $159,000 x 9) / 14 = $147,929.

Your business value calculation now produces a different result:

Business Value = $419,823.

This is around 11% higher than the result you got with the simple average earnings in Scenario 1 above. No surprises here: your earnings input is higher.

What this means is that you expect the business earnings to be in line with the higher values seen in the more recent years. This business growth upside is correctly captured by your Multiple of Discretionary Earnings business valuation.

Each business is unique in the way it creates value. When you need to measure what your business is worth, it is good practice to choose a number of proven business valuation methods.

For example, you may select a method under each of the major business valuation approaches: Income, Market, and Asset. This way, you can ensure that your business valuation results are on a solid foundation.

ValuAdder is designed as a flexible toolkit that makes your business valuations quick, accurate and comprehensive. You can pick the business valuation methods with a mouse click and create valuation scenarios that best match your needs.

And you can do all your business valuation calculations in any currency. ValuAdder automatically adapts to your computer settings and displays the currency that fits your location. You can change the currency at any time. For example, on a Windows computer do the following:

1. Click on the Start menu in the lower left corner of your display.
2. Click on Control Panel and select Regional and Language Options.
3. Now choose your regional format, such as English (United States).

Start ValuAdder to do your business valuation calculations in your regional currency and number format. What’s more, your business valuation reports also use the currency of your choice.

Finding your business value by market comparison

You probably noticed that ValuAdder features a number of market-derived Rules of Thumb. The Rules give you a very effective way to estimate your business fair market value using the well-known Comparative Transaction Method.

In plain words: you determine the business value by comparison with similar businesses that have actually sold. All you need to do is select your business type and provide a few key business financial performance inputs. ValuAdder does a number of calculations to give you the business value range, average and median values.

Locate your business type 3 ways: 1. By Name 2. In Industry Group 3. By Direct Search

With over 350 major industries to choose from you may wonder what it takes to find the right industry for your comparison. ValuAdder engineers thought of this as well – and came up with several handy ways to simplify your work:

• View Rules listed by Name.
• View Rules organized by Industry Group.
• Use the search engine to quickly find the Rule you need.

To see all available business types in alphabetic order, click on the By Name button and scroll to the business type you want.

To look up your business type by Industry Group, click on the By Industry button, then expand the Group view to see all related business types.

For a very quick lookup, use the built-in Search engine: just start typing the business description you are intested in. ValuAdder displays all matching business types immediately.

Now make your selection and specify your key financials such as the business cash flow, revenue, inventory or tangible assets. ValuAdder instantly displays the business value range, average and median values.

You will appreciate the time savings if you need to do a number of market comparisons: when looking for a business to buy or doing a number of what-if valuation scenarios.

Payback period is the time it takes to recover your original investment. If you are buying a small business, that’s your down payment money.

You can use ValuAdder Deal Check tool to factor in your payback period.

Here’s how:

1. Your purchase price and terms 

Enter the purchase price and terms you have in mind. Next, specify the compensation you need for yourself. Don’t forget to enter the “capital expenses” needed to keep the business running smoothly. 

2. Return on down payment 

Now, let’s say you want to get your down payment back within 4 years after the business purchase. Enter 25% into the “Return on Downpayment” input on the Deal Check Tab. This tells ValuAdder that you want to recover your downpayment in exactly 4 years after you close the deal.

3. Does the business throw off enough cash flow? 

Click on the Calculate button to see the cash flow required from the business.

If the actual business cash flow falls short, you can consider a few changes:

• Negotiate a lower purchase price. This, of course, reduces the down payment and cash flow required from the business.
• Lower the down payment amount. You can recover a smaller investment more quickly. Watch the debt service as you use more of “other people’s money”.
• Increase the term of the seller or bank loans. Debt service has a major impact on the business cash flow. Generally, the longer the term, the less cash flow is needed to service it.

Caution: You and your business must be paid! 

Don’t reduce the amount of capital expenses, working capital or your compensation level. You will need to buy new assets and replace old ones as they wear out. And you must pay yourself to meet your own expenses.

Keep the ValuAdder Autocalculate^TM on – it will save you a lot of time as you fine-tune your business purchase terms.

Designed on the leading-edge Java-6 technology, ValuAdder business valuation software is packed with features to simplify and speed up your business valuation.

One of these powerful features is ValuAdder Autocalculate^TM. With Autocalculate^TM on, ValuAdder responds to your inputs by instantly calculating your business valuation results. Refining your business valuation assumptions is a snap especially when coupled with the quick incremental adjustments using the up and down arrows provided on each ValuAdder input.

Here is how you can activate Autocalculate^TM:

1. Run ValuAdder.
2. Click on the Tools menu.
3. Toggle the Autocalculate^TM on. A checkmark indicates that Autocalculate^TM is active.

You will find Autocalculate^TM a real time saver in many business valuation situations, including:

1. What-if scenario analysis.
2. When reviewing a number of business valuation situations with your partners or professional advisors.
3. When developing the terms of a business purchase offer.
4. During negotiations over the terms of a business purchase offer or counter-offer.

One of the greatest strengths of ValuAdder is its flexibility. You will notice that ValuAdder offers you a number of well-known business valuation and deal structuring tools. With all the tools and business valuation methods available to you, you can make the choices that best fit your particular business valuation, business sale or purchase situation.

We discuss the strengths and weaknesses of the various business valuation methods in our Business Valuation Guide. Once you have selected your methods, you can set up your ValuAdder to use them in a just a few key strokes. Here is how:

1. Create a new ValuAdder window by clicking on the File menu and choosing New.
2. Select the valuation methods you want from the Start Tab.
3. Create a Tab for each method you choose by clicking on the Create button.

You can rename your business valuation tools using the Tab menu to make your choices easy to remember. For example, if you are working on a business purchase offer and decide to use the Deal Check tool to structure your offer terms, you can rename the Tab to something like My Offer Terms.

Grouping all your tools in a separate ValuAdder window is an excellent way to organize your work. For example, you can keep all your method selections, your assumptions and valuation calculations together when valuing a specific business. And you can save all your work in one step and then restore it later by using the Save and Open commands in the ValuAdder File menu.

As you know, business valuation depends on a number of key assumptions. Most importantly, your income forecasts for the business influence your valuation results.

Your business plan may include a number of such forecasts. Typically, business people have a set of income and expense projections. Because there is no guarantee how the business will perform in the future, business owners make several projections that reflect possible outcomes. A best case forecast may indicate how the business will do under ideal conditions. If the business conditions deteriorate, a worst case forecast may be a closer fit. The objective here is to be prepared for such situations and prevent problems before they occur.

A standard way to value a business is to use income-based business valuation methods, such as the Discounted Cash Flow or Multiple of Discretionary Earnings. These methods rely on the income projections as their key input. Hence, their business value results will differ depending on which income forecast you use.

To see how your business value changes with each projection, you can use ValuAdder scenario analysis.

Here is how:

1. Make your income and expense projections for each scenario, using the ValuAdder financial recasting worksheets.
2. Select a business valuation method you wish to use, such as the Discounted Cash Flow.
3. Create a Discounted Cash Flow Tab in ValuAdder for each scenario, e.g. Best Case, Worst Case, Most Likely Case.
4. Use your income stream forecasts to calculate the business value for each scenario.

Now you can easily see how your business value changes based on each income forecast. Don’t forget to review the discount rate for each forecast scenario. If the business risk associated with each projection is different, your discount rates for each should reflect this.