When owners ask us, “What’s my business worth?”, the answer is rarely straightforward.  

There are many ways to value a business, but if we break it down in simple terms, there are three very different types of value we are talking about: 

  1. Business value [often referred to as enterprise value] 
  2. Goodwill value [as an asset separate from the other assets necessary for operating the business] 
  3. Company or entity value, which includes the goodwill and business value, as well as  the other assets and liabilities of the company/entity [which change every day] 

The most common approach to valuing a business is called the Capitalisation of Future Maintainable Earnings [FME] methodology. A common misconception is that this represents the goodwill value when in fact, it’s typically the business or enterprise value. 

We summarise the formula for valuing all three of the above as follows: 

Future Maintainable Earnings x Capitalisation Multiple

= Business Value 

– Net Business Assets 

= Goodwill Value 

+ Surplus Assets 

– Surplus Liabilities  

= Company Value

 

breaking down the business value formula

 

For a helpful breakdown of each step in the formula, watch the video below or keep scrolling to dive deeper.  

 

step 1: Future Maintainable Earnings [FME] 

 

This is the level of profits a buyer can reasonably expect the business to generate in the future. It’s not just last year’s profit, it’s a normalised figure that removes unusual one-off items, adjusts for market trends, and reflects the “true” sustainable earning capacity of the business into the future.  

Importantly, the past is just used as a proxy for the future. If business has changed materially you need to adjust the FME to reflect future earning expectations. It’s all in the name; Future Maintainable Earnings [FME]. 

 

step 2: capitalisation multiple 

 

The multiple reflects the estimate multiple of FME someone may be willing to pay for the business based on the risk and return profile. For example:  

  • A strong, stable business in a growing industry will usually attract a higher multiple.  
  • A riskier, more volatile business will attract a lower multiple. 

Think of it this way: the multiple is how many years of earnings a buyer is willing to pay upfront. 

 

The inverse of the capitalisation multiple is the capitalisation rate. For example, a 33% cap rate represents a 3x multiple 

  • The higher the risk in the business, the higher the cap rate and the lower the multiple.  
  • The lower the risk in the business [or opportunities for improvement], the lower the cap rate and the higher the multiple.  

We explain the capitalisation rate as the required rate of return given the risks and opportunities specific to the business at the time of the valuation and given the FME calculated for the business.   

To help you understand how we determine the capitalisation rate, you can visit my blog: how to increase the value of your business. 

 

step 3: business / enterprise value

 

Multiply FME by the multiple and you get the Enterprise Value, essentially, the value of the business operations based on the expected earnings at that point in time and the assessed risk that this will change or there are opportunities to improve it.  

Importantly, earnings is a proxy here for expected cashflows [before tax].   

 

step 4: adjustments to get goodwill value 

 

The value calculated at step 3 is the value of the business or enterprise. This value couldn’t exist if the business didn’t have certain assets tied up in it that are necessary to run the business. This includes things like working capital requirements, stock, plant and equipment.  

These tangible assets necessary for running the business, are deducted from the business value to determine the value of the goodwill within the business as a separate intangible asset.  

The difference between goodwill and business value is commonly misunderstood.  I like to explain it using the following analogy: 

  • If I was starting a new business, I would need to contribute some working capital and buy some assets [maybe equipment and stock] to get things off the ground. 
  • The goodwill value is the value created over and above the value invested in equipment or stock.  
  • Without the amount invested in stock and equipment, the business may not exist. 

 

 

step 5: adjustments to calculate company value  

 

To determine the value of the company or the entity which owns the business, we need to adjust the value of each individual asset and liability of the company or entity at the date of the valuation.  We then also include a value for the goodwill as determined from Step 4.   

Typically, this means we start with the value of the business [which includes goodwill], then adjust for assets and liabilities that are surplus to the business needs.  

It’s important to note here that a business is always valued on an unencumbered basis – meaning we ignore any debt taken out to operate the business.  

Common adjustments here include: 

  • income tax liabilities not yet taken up in the accounts, 
  • leave liabilities not yet taken up in the accounts, or 
  • writing down certain assets to fair market value.   

 

why this matters 

 

Understanding the Capitalisation of Earnings approach and the difference between business, goodwill and company values is critical for: 

  • business owners preparing to sell, 
  • buyers assessing opportunities, 
  • succession planning, 
  • deemed tax valuations, and 
  • leaders making strategic decisions about growth and capital allocation. 

 

we’re here to help 

 

If you’re unsure where your business fits, or you’d like a clearer view of what your business, goodwill or company might be worth, reach out to me at j.knight@businessdepot.com.au or give our crew a buzz on 1300 BDEPOT. 

 

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