How Are Trade Businesses Valued?

What methods are used to value a trade business?

There are three families of method. An income approach values the earnings the business can keep producing. An asset approach values what the business owns, less what it owes. A market approach compares the business with sales of similar businesses.

For an owner-operated trade business the income approach is usually the main method, the asset approach is a floor, and market evidence and rules of thumb are cross-checks. Buyers of these businesses pay for the profit they expect to keep, and reliable transaction evidence for small private trade businesses is often limited, incomplete or not public.

The valuer’s job is to say which method carries most weight and why, and to show that the other methods do not contradict it. Our page on how we value describes the process in our own engagements. In practice the work runs in this order:

1. Collect the financial statements, tax returns and supporting records for several years.
2. Normalise the earnings to what a new owner could expect to keep.
3. Choose the method or methods that suit the business and the purpose.
4. Apply the method, usually a multiple or rate chosen from the evidence on risk and growth.
5. Cross-check the result against other methods and against the assets.
6. Move from enterprise value to equity value where the interest being valued calls for it.

What is capitalisation of maintainable earnings?

It is a three-step method: work out the earnings the business can maintain, choose a multiple or rate that reflects the risk and growth in them, and multiply. The multiple is the inverse of a capitalisation rate, so a multiple of 4.0 and a rate of 25 per cent are two ways of saying the same thing.

The earnings can be measured on an EBITDA or an EBIT basis. EBITDA is earnings before interest, tax, depreciation and amortisation. EBIT is the same measure after depreciation. EBIT is the more careful measure for a business that spends heavily on plant, because depreciation stands in for the cost of replacing it.

Maintainable earnings are not simply the latest year, and they are not just an average. We look at the trend over three years or so and form a view of what is sustainable, giving more weight to recent years where the business has changed in a way that will last, and less where a year was driven by something unusual.

The multiple must match the basis. A multiple that suits EBITDA does not suit EBIT, and applying it to the wrong measure gives the wrong answer, a point we take up in our guide to EBITDA multiples for trade businesses. Done consistently, either basis can reach the same value, as the example further down shows.

When are the assets the main method?

Net tangible assets, meaning the market value of the tangible assets less the liabilities, are a floor for most businesses. An owner would not normally sell for less than the assets could realise after costs if a realistic alternative existed. For asset-heavy businesses, they can become the main method.

That happens when earnings do not justify the assets held: an earthmoving or civil contractor with a large fleet and thin or erratic margins, a business with surplus land or plant, or one that is winding down. We look at what the assets would realise, the cost and time of selling them and whether the business could be worth more as a going concern. Tax on a sale is a matter for the owner’s accountant. Our guide on whether equipment adds to business value goes through the logic.

Why is discounted cash flow less common for smaller trade businesses?

A discounted cash flow values the business as the present value of its forecast cash flows. It fits where cash flows can be forecast with some confidence: a business with long contracts, a defined growth plan or a significant change coming, such as a major contract or a new division.

Most smaller trade businesses do not look like that. Work is won month to month, forecasts rest on the owner’s opinion, and the result is very sensitive to the discount rate and the assumed long-term growth. A small change in either moves the value a lot, which can give an impression of precision that is not there. So we use it mainly as a cross-check, and as a primary method only where the forecast can be tested against contracts and history.

Where do rules of thumb fit?

As cross-checks only. A rule of thumb expresses value as a multiple of turnover or profit, or as some weeks of revenue. They are quick and easy to remember, but they ignore what makes one business worth more than another with the same turnover: margins, owner wages, customer concentration, the condition of the fleet and the evidence for the earnings.

A rule of thumb can tell a valuer that a conclusion looks unusually high or low and deserves a second look. It cannot be the conclusion. We do not quote any here as figures, and a result that rests on one is not a valuation.

What is the difference between enterprise value and equity value?

Enterprise value is the value of the operating business. Equity value is what belongs to the shareholders after debt and other adjustments. An earnings approach gives enterprise value first, because the earnings are measured before the cost of finance. Getting to equity value takes four steps:

• Add surplus assets: assets that do not contribute to the earnings, such as spare land or idle plant, at market value.
• Deduct interest-bearing debt, including equipment finance and loans.
• Add cash that is not needed to run the business.
• Adjust for working capital if the business holds more or less than it needs for normal operation.

Notice that the equipment is inside the $800,000 and the finance on it comes off afterwards. The normal level of working capital is judged from how the business runs across the year, not from the balance on a single day. Who owns the land, whether the debt is a company liability and how a sale would be structured are questions for the owner’s accountant and lawyer.

Why does normalisation come first?

Because every method starts from earnings, and reported earnings are rarely the earnings a new owner would keep. Normalisation rebuilds them: it replaces the owner’s drawings with a market cost for their work, removes private expenses and one-off items, puts related-party rent at a market level and adjusts for revenue that will not repeat.

It runs in both directions, and each adjustment needs evidence. An unsupported add-back can overstate value as surely as an overlooked cost can understate it. For a worked case, see our illustrative plumbing example.

How do purpose and valuation date change the valuation?

The purpose decides what is being valued and for whom. A sale, a shareholder buy-out, a restructure, a capital gains tax question, a dispute and estate planning each ask slightly different questions: whether the interest is the whole business or a share of it, whether control or marketability matters, and who will rely on the report. The engagement sets this out at the start. Our pages on business sale, capital gains tax, shareholder transfer and dispute valuations cover how each is handled.

The valuation date matters because a valuation is as at a point in time, using what was known or knowable then. A current valuation, a historical date for a past event and a date for a future transaction are different engagements. Where a second date is needed, an additional historical valuation date is available from $495 + GST where the engagement permits it. Whether a valuation meets a particular tax or legal requirement is a question for your accountant, tax adviser or lawyer. See pricing for how engagements are priced.