By far the most commonly used method of valuation for the majority of small to medium sized businesses is the price earnings ratio method of business valuation.
The price earnings ratio method values a business as a whole by applying a multiple to its after tax profits, rather than valuing the goodwill and the net tangible assets separately.
To arrive at a goodwill value using the price earnings ratio method one needs to deduct the net asset value of the business from its value as a whole and thus arrive at the goodwill value (if any).
In other words, the goodwill (if any), is the difference between the total value of the business and its net asset value.
This is sometimes referred to as negative goodwill (where the value of these assets of the business in some other use exceeds the value of these assets of the business itself). These circumstances would lead to what is commonly known as “asset stripping” where the purchaser will strip a business of its assets for the value which enable him or her to acquire the business for nominal or bargain price.
The Keys to the Price Earnings Ratio Method Are:
1) What price earnings ratio one chooses to multiply profit by;
2) What profit figure do you multiply by the P/E ratio?
· Businesses run as owner operator or a group of managers, small capital, highly competitive, high mortality rate = x 2 times
· Personal service businesses, requiring virtually no capital. Management has special skills and intensive knowledge of the business. Earnings reflect his skills – can it be continued without him? X 1 times.