There are a number of ways to value a business with most specialists regarding discounted net present value of the future cash flows as being the most realistic method. This method estimates what free cash is available to the business owner each year for five years, adds a terminal value (a discounted value from the following five years) at the end of five years & then discounts all the five years worth of cash back to a dollar value in today's terms. After all, a business owner is really only interested in what he can take from the business.

Given that we want the value of the business as a stand-alone cash-generating machine, we must incorporate a reasonable value for salaries of the operator into the normalised and adjusted earnings. An easy comparison of a cash generating machine for a business owner is to put his or her money into a term deposit and earn interest at the prevailing rate and not have to work, therefore in order to compare apples with apples a stand alone business would have salaries associated with managers.

Now as you can imagine, knowing what those future available cash flows is going to be is difficult so we model out various growth/decay scenarios for the business into the future and include expected capital replacement requirements. If we model future growth, then we also need to incorporate growing working capital requirements. Growing businesses divert cash away from the owner and into larger stock & debtor carries. Less cash coming out the tap makes the business less appealing.

Finally, to get these future cash flows back into a dollar value in today's terms we need to use a discount rate. This rate is associated with the riskiness of the business and the reward expectations of a buyer. For example, an investor may buy a term deposit for $100,000 from a bank for 1 year with an iron clad guarantee that he will earn $7,000 from that deposit and get all his money back at the end the life of the deposit. A business purchaser faces many more risks and therefore would want much more than $7,000 from 1 year of owning a business that he/she paid $100,000 for; how much more is the big question. This question can be answered by considering the riskiness of the business. For a low risk business, an investor may be satisfied with merely two or three times what is paid by a term deposit. For a high risk business the expected return could be many times the rate paid by a term deposit.

By now you can see that valuation is a hazy non-precise endeavour that requires many assumptions about the future of the business and expectations associated with rates of return. For this reason, a valuation should take into account many different scenarios associated with these variables to build out a whole range of possible values.

Another method of business valuation that is used quite frequently is to assess the future maintainable earnings of a business based on past earnings and then apply some multiple to those future maintainable earnings to derive a valuation. If this method is used, it is important that the business has a relatively stable earnings history. To suggest that the future earnings of a business will be like they were in the past is very naive especially if the past was unstable. Stability in the past provides some small confidence that there may be stability in the future.

Where do you then get your earnings multiple to multiply your calculated maintainable earnings by in order to derive a value? Well as it so happens, share prices for listed companies are readily available together with those companies earnings. With the enterprise value of a listed company and its EBITDA (Earnings Before Interest Tax Depreciation & Amortization) it is a simple matter of deriving an earnings multiple that is backed by the marketplace.

If you can find a listed company that operates a business that is the same as yours or similar then you might consider applying the earnings multiple from the listed company to yours in order to derive a value. Given that a listed company is probably orders of magnitude larger than a small privately owned business with more opportunity for growth and more economies of scale it is worth reducing the earnings multiple of the publicly listed company to apply to the earnings associated with the privately owned business in order to derive a value. Here again, it is worth ranging the discount of the publicly listed companies' earning multiple.

There are two more very important points to consider when using the earnings multiple of a publicly listed company. Firstly, use the appropriate earnings multiple. Earnings to market capitalisation gives a ratio that associates earnings to equity. An earnings to enterprise value gives a ratio that associates earnings to the value of the actual enterprise or business. Market capitalisation of a business is different to the enterprise value of a business by the debt carried by that business. After all, equity or market cap is equal to assets less liabilities. It is equity plus debt that supports the assets of a business and enables the business to generate future maintainable earnings. Secondly, this method of calculating a business value is really more useful in comparing values of like for like businesses rather than providing a true value. After all, market caps are a moving target on stock exchanges and can shift dramatically in even a few days as markets twist & turn.