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This approach to valuing a business provides another way to skin the same cat, and is called the capitalised earnings method. This method is more commonly used by the buyer rather than the seller, because the final valuation is so reliant on the rate of return that the buyer requires.

Here’s how it goes:

1 Work out the EBITDA.Sounds like I’m rapping. But no, I’m actually talking about Earnings Before Interest and Tax, Depreciation and Amortisation. I explain this calculation in the section ‘Calculating the ‘True’ Earnings of a Business’, earlier in this chapter.

2  Decide what you want as your rate of return.This figure is usually how much you’d get from the current bank deposit rate plus an allowance for the risk you’re taking. For example, if the deposit rate is 2 per cent, you may want to add another 8 per cent for the risk you’re taking, and so decide to aim for 10 per cent as your rate of return. (My example here reflects the rates at time of writing, which are historically low. Of course, deposit rates may have changed by the time you’re reading this.)

3 Divide the EBITDA by your desired rate of return.The result of this calculation is called capitalised earnings. For example, if the average EBITDA of a business is $50,000 and you want a return of 10 per cent, capitalised earnings would be $500,000. Or, if you want a return of 15 per cent because your perceived risk is higher, capitalised earnings would be $333,333. This capitalised earnings figure represents how much the business is worth in your eyes, given the rate of return that you’re seeking. As the examples show, the business valuation goes down as the risk (and so required rate of return) goes up.

I mention wages earlier in this chapter, but don’t forget to adjust the EBITDA to allow for the time owners spend working on the business. This adjustment is particularly important when looking to buy a sole trader or partnership business, because the financials will not include wages paid to owners. For example, a business may look great on paper, showing average profits of $100,000 per year, but if this business is run by a couple who each work 60 hours per week, these profits are not really profits at all.