A key challenge in valuing a business is making sure that certain aspects of that business are directly comparable with those of other similar businesses.

For instance if I know that widget manufacturer typically sell for three times earnings and I am valuing a widget manufacturer then it’s likely that I will value the business at around three times earnings.

Removing the ‘noise’ from the calculation of earnings

If earnings is not calculated in the same way each time a business valuation is conducted, then earnings figures will not be directly comparable to other similar businesses and the results will be meaningless. It is the job of a valuer to remove the ‘noise’ from the earnings figures to ensure a good like for like comparison.

One of the biggest sources of ‘noise’ in a business income statement (or profit & loss) is the owners’ wage, because often owners do not pay themselves a market wage. Either preferring to pay themselves an inflated wage or little to no wage at all and take their income from the profits of the business. This can make a significant difference to the calculation of earnings and therefore it needs to be adjusted for.

Finding a fair wage usually requires research and benchmarking, however it is also important to look beyond salary. It is possible that an owner may not draw any salary from their business but they derive other benefits for themselves their partner and their children which may be expensed through the business, for example a leased car not used in the running of the business, these and other benefits can be considered as an ‘in kind’ salary.

Whilst it is possible that an owner requires a vehicle for their business, the costs of the vehicle must be reasonable. For example when an owner of a business expenses a top of the range Porsche through their business this might be considered an unreasonable level of expense or benefit in kind, if it cannot be justified.

In my above example using a multiple of three means that a difference in a ‘fair and reasonable’ salary of $100,000 would lead to a difference in the final valuation of $300,000. Therefore it is critical that all owners’ salaries and benefits are reliably benchmarked.

Should you require any Valuation, Litigation Support or Forensic Accounting services contact Gary Fettes and Mark Ellis of Rodgers Reidy on (03) 9670 8700.