By Jaap van der Westhuizen, AGA(SA)
PPRA-registered business broker | Cape Business Bureau
Valuing a privately owned business is not a matter of entering one figure into a calculator and accepting the answer. It combines financial analysis with commercial judgement. The calculations matter, but so do the quality of the earnings, the risks attached to those earnings and the likelihood that the business will continue performing under a new owner.
For a seller, the valuation helps establish a defensible asking price. For a buyer, it provides a basis for deciding whether the expected return justifies the purchase price and risk. It does not guarantee the final price. The eventual transaction price is still influenced by negotiations, payment terms, working capital, stock, debt, seller finance, warranties and the conditions attached to the offer.
Cape Business Bureau has assisted South African business owners and buyers since 1953. In practice, we consider more than one valuation method where the quality and history of the available information allow it. The methods must then be reconciled rather than averaged mechanically.
Value, asking price and selling price are not the same
These terms are often used as though they mean the same thing, but they serve different purposes.
- Indicative value is a reasoned estimate based on available information, assumptions, risk and a specified date.
- Asking price is the price at which the seller chooses to take the business to market.
- Selling price is the amount ultimately agreed between buyer and seller, together with the applicable payment terms and conditions.
A seller may want a particular amount because of retirement plans, debt or the years invested in the business. Those personal considerations are understandable, but they do not determine what a buyer will pay. A buyer is primarily concerned with future benefit and risk.
A valuation should also state what has been valued. The operating business, the shares or members’ interest, stock, working capital, surplus cash, debt and property do not automatically form one package. If the basis is unclear, two people can quote different values while both believe they are referring to the same transaction.
The three broad valuation approaches
Professional valuation practice commonly groups methods into three broad approaches:
- Income approach: Value is derived from future income or cash flow.
- Market approach: Value is informed by comparable companies or transactions.
- Asset or cost approach: Value is linked to the assets and liabilities, or the cost of replacing relevant assets.
Within these approaches, Cape Business Bureau may consider four practical methods for an owner-managed business:
- A multiple of normalised or maintainable earnings
- Market comparisons, including comparable private transactions and listed-company evidence where relevant
- Discounted cash flow
- Net asset value and asset replacement considerations
The right method depends on the business. A profitable service business with few physical assets should not be assessed in exactly the same way as a capital-intensive manufacturer or an asset sale where sustainable earnings cannot be demonstrated.
Start with reliable information
A valuation is only as reliable as the information on which it is based. Before selecting a method, the valuer or broker needs to understand the business and test whether the financial history is complete and representative.
Useful information normally includes:
- Financial statements for the latest three to five years, where available
- Current management accounts
- Detailed income statements or general-ledger information
- VAT and relevant tax records
- Debtors, creditors, stock and work-in-progress schedules
- Asset registers and finance obligations
- Owner remuneration, drawings and benefits
- Details of private, once-off or non-core expenses
- Customer and supplier concentration
- Recurring revenue and contract information
- Employee and management structure
- Lease terms and property arrangements
- Capital expenditure and maintenance requirements
- The owner’s role and hours worked
- Known disputes, contingent liabilities or compliance matters
- Realistic forecasts supported by the business’s history and current position
Financial statements provide an important starting point, but they do not explain every commercial fact. A valuation discussion should include the owner because the owner can explain unusual items, changes in trading conditions, customer movements and future commitments.
Step one: normalise the earnings
Owner-managed businesses often contain income and expenses that will not continue in exactly the same form after a sale. The historical result therefore needs to be reviewed to estimate a maintainable level of earnings.
Potential adjustments may include:
- Owner remuneration and benefits
- A market-related replacement salary where the buyer will need to employ management
- Private expenditure passing through the business
- Once-off legal, relocation or restructuring costs
- Non-recurring insurance proceeds or exceptional income
- Related-party rent that is above or below market terms
- Expenses that will increase under new ownership
- Income that is unlikely to continue
- Deferred maintenance or capital expenditure
An item should not be adjusted merely because removing it produces a higher value. Every adjustment should be identifiable, supportable and commercially reasonable.
Illustrative normalisation example
Assume the reported profit before tax, after the owner’s remuneration, is R1,200,000. The following illustrative adjustments are identified:
- Add back owner remuneration: R600,000
- Deduct a market-related replacement manager’s salary: R480,000
- Add back a genuine once-off legal expense: R120,000
- Add back documented private expenditure: R180,000
- Deduct exceptional income that will not recur: R150,000
The resulting indicative normalised earnings would be R1,470,000.
This example does not mean every owner’s salary or expense may be added back. If the business requires someone to perform the owner’s work, the cost of that person must be allowed for. The purpose is to estimate sustainable earnings under a realistic ownership and management structure.
Method 1: Multiple of normalised or maintainable earnings
This is a commonly used approach for profitable privately owned businesses. Once maintainable earnings have been determined, an appropriate factor or multiple is applied.
The calculation is conceptually simple:
Indicative business value = maintainable earnings × selected multiple
The difficult part is not the multiplication. It is deciding whether the earnings are sustainable and selecting a multiple that properly reflects the business’s quality and risk.
For smaller owner-managed businesses, seller’s discretionary earnings or a similar owner-benefit measure may be useful. For larger businesses with established management, an EBITDA-type measure may be more relevant. The chosen earnings measure must be applied consistently and explained clearly.
Factors that may support a higher multiple
- Consistent, verifiable profitability
- Recurring or contracted income
- A diverse customer base
- Low dependence on any single supplier
- Capable management and employees
- Limited dependence on the outgoing owner
- Documented systems and processes
- Transferable contracts, licences and intellectual property
- Sustainable competitive advantages
- A secure, affordable lease where premises are important
- Modest ongoing capital requirements
- Credible growth supported by evidence
Factors that may reduce the multiple
- Volatile or declining earnings
- Poor financial records
- Heavy dependence on the owner
- Customer or supplier concentration
- Short-term or uncertain contracts
- Key staff who may leave
- Lease, licence or regulatory uncertainty
- Deferred maintenance or significant capital requirements
- Unresolved disputes or compliance problems
- Aggressive forecasts unsupported by trading history
- A narrow pool of suitable buyers
There is no universal multiple for privately owned businesses in South Africa. A broad rule quoted without reference to the industry, size, earnings definition, risk and transaction terms can be misleading. Even businesses in the same industry may deserve different multiples.
Method 2: Market comparisons
The market approach compares the business with evidence from similar companies or completed transactions. This may include:
- Sales of comparable privately owned businesses
- Industry transaction data
- Market evidence from similar opportunities
- Listed-company valuation measures where they are genuinely relevant
Listed-company comparisons require particular care. A listed group may be larger, more diversified, professionally managed, liquid and able to obtain funding on better terms. Its shares can also be traded more easily than an interest in a small private company. A listed-company multiple should therefore not be transferred directly to an owner-managed business without appropriate adjustments.
Comparable private transactions can also be difficult to use because full information is not always public. The quoted price may include property, stock, cash, debt, working capital, seller finance or an earn-out. Without knowing those details, the headline price can create a false comparison.
The market approach is most useful when the comparator is genuinely similar and the basis of the transaction is understood.
Method 3: Discounted cash flow
A discounted cash-flow valuation estimates the future cash the business is expected to generate and converts those future amounts into a present value. The discount rate reflects the time value of money and the risk attached to achieving the forecast.
A DCF assessment normally requires:
- A realistic trading forecast
- Normalised operating cash flows
- Working-capital assumptions
- Capital-expenditure requirements
- An appropriate forecast period
- A supportable long-term or terminal assumption
- A discount rate consistent with the risk
DCF can be useful where future cash flows can be forecast with reasonable confidence. It is also sensitive to assumptions. A small change in growth, margins, working capital, capital expenditure or the discount rate can materially change the result.
The forecast should therefore be tested against historical performance, current contracts, capacity and market conditions. A valuation should not rely on an optimistic spreadsheet that the business has never demonstrated it can achieve.
For a small business with volatile earnings or limited reliable forecasts, DCF may be better used as a cross-check than as the only valuation method.
Method 4: Net asset value and replacement considerations
The net asset value approach considers the fair or realisable value of the relevant assets less the applicable liabilities. It may be particularly useful for:
- Capital-intensive businesses
- Property or investment-holding entities
- Businesses with valuable machinery or specialised equipment
- Asset-value or distressed opportunities
- Businesses that cannot demonstrate sustainable earnings
- A reasonableness check against another method
Important distinctions must be made between:
- Historical cost in the accounting records
- Book value after depreciation
- Current market or realisable value
- Replacement cost
- The value of assets as part of an operating business
Replacement cost does not automatically equal market value. A buyer may not pay the cost of replacing an old machine if a suitable used machine is available for less, or if the asset does not generate sufficient earnings.
Similarly, a profitable service business may have limited tangible assets but substantial goodwill, customer relationships, systems and recurring income. An asset-only method could undervalue that business.
Assets should also be checked for outstanding finance, leases or security such as a notarial bond. The parties must understand whether an asset can transfer and whether related debt will be settled.
What about goodwill and intangible value?
Goodwill is often described as the value above the identifiable net assets of the business. In practical terms, it may be supported by:
- Customer relationships
- Recurring revenue
- Reputation and trading history
- Brand and trademarks
- Supplier arrangements
- Location
- Systems and operating know-how
- Employees and management
- Licences or approvals
- The ability to generate earnings beyond a fair return on the tangible assets
Goodwill is not simply an amount inserted to make the asking price work. It must be supported by transferable commercial advantages and sustainable earnings.
If customers only remain because of a personal relationship with the outgoing owner, the goodwill may be less transferable. A planned handover, contractual relationships and capable staff can strengthen continuity.
Owner dependence can change the value materially
Two businesses with the same reported profit may not have the same value.
Business A may have a management team, documented processes, diverse customers and limited owner involvement. Business B may depend on the owner for sales, technical work, supplier relationships and every important decision.
A buyer of Business B must either replace the owner’s skills and time or perform the role personally. This affects normalised earnings, the risk assessment, the buyer pool and potentially the payment structure.
Owners considering a future sale can improve transferability by documenting processes, developing management, sharing customer relationships and reducing reliance on knowledge held by one person.
Working capital, stock, debt and property must be reconciled
An indicative operating-business value does not automatically answer how much the seller will receive.
The final consideration may need to address:
- Whether stock is included or valued separately
- The normal level of working capital required at takeover
- Treatment of debtors and creditors
- Cash retained or transferred
- Interest-bearing debt and asset finance
- Surplus or redundant assets
- Property included in or excluded from the transaction
- Seller finance, deferred payments or earn-outs
- Transaction costs and tax
These items should be made clear before the business is marketed and again when an offer is negotiated. Otherwise, a buyer and seller may agree on a headline value but disagree about what that figure includes.
Do not average valuation methods mechanically
Using several methods is useful because each examines the business from a different angle. However, taking a simple average of four unrelated results does not automatically produce a reliable answer.
The methods should be reconciled according to their relevance and the quality of their inputs. For example:
- Maintainable earnings may deserve greater weight for a profitable service business.
- Asset value may carry more weight for a machinery-intensive operation.
- DCF may be relevant where cash-flow forecasts are credible and supportable.
- Market comparisons may be useful where genuinely comparable transaction evidence exists.
If one method produces a very different answer, investigate why. The difference may reveal an unrealistic forecast, understated asset requirements, poor comparability or a business that is not earning an adequate return on its asset base.
Valuation is a range, not false precision
A privately owned business valuation is normally more useful as a supportable range than as an apparently exact figure. The range reflects the available evidence, the sensitivity of assumptions and the terms on which the business may be sold.
The value can also change over time. A lost customer, new contract, lease renewal, management appointment, decline in earnings or significant capital purchase can affect the assessment. A valuation should therefore have an effective date and should be reviewed if circumstances change materially.
How a seller can improve valuation readiness
Before requesting a valuation, a seller should:
- Bring financial statements and management accounts up to date
- Reconcile turnover to supporting records
- Prepare a clear schedule of proposed earnings adjustments
- Separate private expenditure from genuine operating costs
- Document the owner’s role and a realistic replacement cost
- Prepare customer and supplier concentration information
- Confirm recurring revenue and transferable contracts
- Review employee and management dependence
- Update the asset register and finance schedule
- Clarify stock and working-capital requirements
- Review the lease and renewal position
- Record licences, trademarks, systems and intellectual property
- Identify disputes, compliance matters and future capital requirements
- Prepare a realistic explanation of growth opportunities and risks
Reliable information does not guarantee a particular value, but it gives the assessment a stronger foundation and makes it easier to explain to a serious buyer.
Common valuation mistakes
- Valuing the business on turnover alone
- Applying an industry multiple without defining the earnings figure
- Adding back every owner-related expense
- Ignoring the cost of replacing the owner
- Using listed-company multiples without private-business adjustments
- Treating an asking price on another website as evidence of a completed sale
- Forecasting growth that the business has not demonstrated
- Ignoring working capital and capital expenditure
- Treating replacement cost as market value
- Failing to account for debt or asset finance
- Overlooking customer, supplier or key-person dependence
- Averaging different methods without understanding the differences
- Presenting a precise figure despite weak information
Final thoughts
A sound valuation combines reliable financial information, appropriate methods and practical commercial judgement. The calculation should be capable of explanation to both seller and buyer. It should also make clear what is included, which assumptions have been used and where professional advice is still required.
Cape Business Bureau can assist with a practical, market-related assessment of a privately owned business and advise on how it should be prepared and positioned for a confidential sale.
Considering selling your business? Contact Cape Business Bureau for a confidential discussion about the value, preparation and potential sale of your business.
About the author
Jaap van der Westhuizen, AGA(SA) is a PPRA-registered business broker with more than 25 years of commercial experience. He assists business owners and prospective purchasers through the practical stages of business sales, valuations and acquisitions at Cape Business Bureau.
This article provides general business-broker guidance and is not a formal valuation or a substitute for legal, tax, accounting or financial advice. A formal valuation may require a suitably qualified independent valuer, depending on its purpose. Circumstances, assumptions and transaction terms differ, and professional advice should be obtained before making or accepting a binding commitment.
Professional references
