Understanding Your Business’s Value

Proposed changes to the CGT rules are expected to make business valuations more important than ever for private business owners. From 1 July 2027, the current 50% CGT discount will be replaced by an indexation-based approach, requiring many business owners to determine the market value of their business as at 30 June 2027. For those who have never previously needed a formal valuation, understanding how business value is determined has become increasingly important.

In this first article of our valuation series, we explore the most common methodologies used to value a business. While every valuation is unique, understanding the principles behind these approaches can provide valuable insight into what drives business value and why two businesses with similar profits can have very different valuations.

The most common valuation methodologies include the Capitalisation of Maintainable Earnings, Discounted Cash Flow and Net Tangible Asset approaches. Understanding how these methodologies work is the first step towards understanding what your business may be worth.

Capitalisation of Maintainable Earnings

The Capitalisation of Maintainable Earnings (CME) method is one of the most widely used approaches for valuing established businesses with a consistent history of profitability. At its core, the methodology seeks to answer a simple question: how much would a buyer pay today for the future earnings of the business? The method does this by determining the level of earnings that can reasonably be maintained into the future and applying a multiple that reflects the risk and growth prospects of the business.

A key step is determining Future Maintainable Earnings (FME), being the level of earnings a purchaser could reasonably expect the business to generate on an ongoing basis. This often requires adjustments to historical results to remove one-off transactions, non-commercial items, owner-specific expenses and other factors that may not reflect the future performance of the business.

Once maintainable earnings have been established, an appropriate multiple is selected. The multiple reflects the risk and growth prospects of the business and is influenced by factors such as industry conditions, competitive position, customer concentration, reliance on key personnel and expected future growth. EBIT and EBITDA multiples are commonly used as they focus on the underlying operating performance of the business by removing the impact of financing and tax structures. Businesses with stronger earnings, lower risk and better growth prospects will generally attract higher multiples than businesses with less predictable performance.

As a result, two businesses with similar earnings can often have significantly different valuations depending on their risk profile and growth prospects.

Importantly, many of the factors that influence a valuation can be improved over time by business owners. In our next article we will explore some practical steps business owners can take to maximise business value.

Discounted Cash Flow (DCF)

The Discounted Cash Flow (DCF) method is based on the principle that the value of a business is determined by the future cash flows it is expected to generate. Under this approach, projected cash flows are estimated over a forecast period and then converted into today’s dollars using a discount rate that reflects the risks associated with achieving those returns.

A DCF valuation requires consideration of three key factors, the amount of future cash flows expected to be generated, the timing of those cash flows, and the discount rate applied. Generally, businesses with stronger, more predictable cash flows will attract higher valuations, while businesses with greater uncertainty will attract lower valuations.

As forecasting future performance involves a significant degree of judgement, DCF valuations typically rely heavily on management forecasts and assumptions. For this reason, the methodology is most commonly used for businesses where future growth is expected to be a key driver of value, such as high-growth businesses, start-ups, major projects, or businesses with finite asset lives.

Net Tangible Assets

The net tangible asset method values a business based on the market value of its tangible assets less its liabilities. In applying this approach, assets and liabilities are adjusted to reflect their true market value, rather than simply relying on the figures recorded in the financial statements.

This methodology is most commonly used for asset intensive businesses, such as property holding entities and investment businesses, where the underlying assets are the primary driver of value.

However, the net tangible asset method does not typically capture the value of intangible factors such as goodwill, brand reputation, customer relationships, market position or the experience of management. As a result, it may understate the value of profitable businesses that generate earnings above and beyond the value of their tangible assets.

For this reason, earnings based methodologies are often preferred for trading businesses, as they better reflect a business’s ability to generate future profits and create value over time.

Looking ahead to 30 June 2027

With the proposed CGT changes expected to require many private business owners to establish the market value of their business as at 30 June 2027, the time to start thinking about your valuation is well before it is required. The factors that influence business value are being created today, and understanding them now can help you better prepare for both future CGT obligations and broader business objectives.

In our next article in this valuation series, we will explore the key drivers of business value and the practical steps business owners can take to maximise value.

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Disclaimer: This information is general in nature and should not be relied on as advice. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs and seek professional advice before making any decisions based on this information.