Economic Approach to Business Valuation & Calculation

Economic Approach to Business Valuation

The economic approach to business valuation places a strong emphasis on the return on invested capital (ROIC), typically referred to simply as “the return,” of a business investment. The financial return of a business is typically the biggest consideration a business buyer has when deciding if he or she should invest in a small business (as should be expected when investing tens or hundreds of thousands of dollars!).

It should be noted that a business seller will also typically weigh the return on invested capital they receive from their business investment that they own/operate when deciding if they should sell the business. After all, they would likely need to find a suitable replacement to what can be a very significant return. The findings of renowned author, speaker, business consultant, and accountant Greg Crabtree places the return on invested capital of a profitableWhen the earnings in a given period of time is more than the expenses in a business…. business with 15%+ profitability in terms of net income at a minimum of 50%. More often than not, the return for a business of 15% or more net income is above 75%. How many investment opportunities exist where an investor can achieve a 50% annual return? (Hint: not many.)

Let us take a look at how the economic approach to business valuation is used in practice.

How is it calculated: profits divided by total investment in the business

When to use it: best company valuation method for existing businesses with 2-3 years of financial history available when the near term (2-5 years) economic outlook for the business looks steady

Pros

Calculates the most important metric, return on invested capital, for the potential business buyer
Can calculate easily if the right information is available
Creates clarity for the business buyer to base their decision off of
Most relevant for owner-operators

Cons

Illustrative Example Business Case for Calculating Business Valuation Using the Economic Approach

The economic approach to business valuation can best be demonstrated by going through an example. In this scenario, the buyer, Tom, has spent some time reviewing existing businesses listings and has whittled down his choices. At the moment he is deciding between purchasing one of two existing business options. Option A is a pastry store called Isabel’s Pastry Shop. Option B is a fitness studio called Fred’s Fitness Center. As both businesses have been open for over three years with available historical financial data, Tom decides to value the businesses according to the economic method.

Below are the steps that Tom will take in order to calculate the value of each of the business options he is analyzing:

Step 1
(data collection)

Gather all of the historical data for each of the businesses, including business projections for the next five years.

Step 2
(review and forecast)

Review the financials, particularly the projections for the next five years to ensure that the forecasts of future cash flowThe net profit before taxes plus payments to the owner(s), interest, and depreciation of assets…. are consistent with results from the past 2-3 years.

Step 3
(calculate return)

Based off of the projections, calculate if the investments reach the required rate of return on invested capital

Step 4
(decision)

Based off of the projected returns, decide if the investment is made or not

Calculating the Inputs

Step 1 (data collection)

Tom, the business buyer, requests the historical financials, including recent tax returns, profit and loss statements, balance sheetOne of the major financial statements for a business that reports a company’s assets, liabilities, and stockholders’ equity typically in that order. Assets and liabilities are also listed from most to least liquid…., cash flowThe net profit before taxes plus payments to the owner(s), interest, and depreciation of assets…. statement, and projections of the business, in order to gain a better understanding of the business. Additionally, Tom requests profit and loss projections for the next five years from both of the businesses.

Step 2 (review and forecast)

With the financial data verified, Tom focuses much of his attention on the projections for the next five years. He knows that due to his prior experience managing successful small businesses that he can decrease costs and increase the salesThe total amount in dollars made in the business before expenses are deducted. See also Gross Revenue…. for both of the businesses. However, he is more confident in his ability to operate Fred’s Fitness Center as he himself is a former fitness trainer with experience managing a gym.

Step 3 (calculate returns)

Tom then calculates the returns he believes he would receive based on the price each business is asking as well as the business projections he has made.

Step 4 (decision)

Based off of the return to each of the businesses, one of them, Fred’s Fitness Center, has significantly higher returns and exceeds the required return on invested capital that Tom needs in order to move forward.

Important note – the focus on this example was launch capital as it is the simplest to understand and calculate. In this example, the launch capital was comprised of the purchase price as it was assumed that the purchase price included fully capitalizing the business with the required buffer and trade capital.

Summary

The economic approach to business valuation is very useful in simplifying the investment decision for the business buyer. The business buyer can calculate the return on their invested capital based off of the financial projections. As the financial projections are key to the investment decision, the economic valuation method should be more utilized for businesses with an establishedThe year a Business for Sale was established. If the business has been running for a minimum of ten years, Vetted Biz will qualify the business for sale as a “Well-Established Business.”… track record as well as stable economic future rather than businesses that are extremely unstable or relatively new.

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Economic Valuation