The following is a brief description of the most common valuation methods used for valuing small to medium sized private businesses.

One or more of these methods are used depending on the nature and size of the business.

Method 1: Asset Based
This method focuses on the assets net of the liabilities. It does not take into account the profitability of the business and is the most appropriate method for under performing businesses, new businesses or any business where the sale of the assets outweigh the sale of the business as a going concern.

Method 2: Capitalised Future Earnings
With this method the value of the business is determined by the future profits that the business will generate for its owners. For most private businesses, Capitalised Future Earnings is the valuation method of choice and takes into account the Adjusted Profits and Return On Investment.

Before looking at this method, we should clarify the basis for which a Return on Investment is calculated. The Return on Investment (ROI) relies on the level of internal and external risks associated with a business, and assumes that the lower the risk, the lower the ROI, and resultantly the greater the value of the business. As investments go, businesses are generally considered riskier than government bonds, property and shares. As a result the lowest ROI achievable is approximately 20%. Beyond that figure an ROI of between 20% and 100% is calculated based on several risk factors that may be associated with the business.

For example, if someone who owns and manages his or her own business decides to sell it, a buyer could see the business as being too heavily reliant on that person. They would be right to ask questions like; how will the business be affected if the current owner leaves? This represents a high risk and as such the ROI will be considerably higher than if somebody else was managing the business.

Now that we understand the concept of how the ROI is established, the following equation should make more sense. Essentially, by dividing the businesses adjusted profits by the ROI we come to the price of the business.

Example:
An owner manager wants to sell their business, but a new manager will be employed when the business is sold. The following table serves to calculate the Adjusted Profits.

 2012 2013 2014 Sales \$1,000,000 \$1,200,000 \$1,400,000 Cost of goods \$750,000 \$900,000 \$1,050,000 Gross profit = \$250,000 = \$300,000 = \$350,000 Expenses \$200,000 \$220,000 \$250,000 Other expenses \$5,000 \$10,000 \$15,000 Net Profit = \$45,000 = \$70,000 = \$85,000 Addbacks Interest on Loan \$25,000 Owners wage and benefits \$130,000 New managers wage -\$110,000 Total Addbacks \$45,000 Total Adjusted profits =\$130,000