If you intend to buy a business, one of the first questions you have is: how much should I pay for the business? Business valuations are made up of several components, one or more of which will make up the purchase price.
1. Equipment purchased: many businesses for sale include equipment needed to run the business. This could include specialised machines, shop fittings, motor vehicles and tools. If this equipment is second hand, you need to assess both its market value and how critical it is to the operation of the business. If the equipment is specialised and hard to replace, it may be worth buying. However equipment that is outdated or could be easily replaced by new equipment that does not require as much maintenance might not be worth buying.
2. Net profit produced by the business. Companies listed on the stock exchange are most often valued by reference to their P/E ratio, where P = Price of a share and E = earnings (or net profit) per share. A large company might have a P/E ratio of between 10 and 15. This means that the price of a share (value of the business) is between 10 and 15 times of one year of net profit per share. Smaller private businesses are not worth as much and would typically have a P/E ratio of between 3 and 7 times. In order to value a business by using the P/E method, there should be at least two or three years of financial accounts, where the profit has consistency from year to year.
3. Intangible assets-trademarks, patents, licences: not many small businesses have any trademarks or patents that they can sell. One example of an intangible asset that is worth money is when a franchise licences a business to use its name and systems.