Business value is normally arrived at by capitalising profits (or cash flows). Profits represent the purchaser’s return on investment and the reason he is prepared to pay the purchase price. But there are various types of profit, so what do we mean by the term ‘profit’ and what profit should be used in business valuations? There are three kinds of profit that you should know about, namely ‘real’ profit, ‘super’ profit and ‘future maintainable’ profit.

The published profit of a private business often gives a distorted view of the real profit of a business. This is because the business owners sometimes arrange matters so as to minimise taxation. On the other hand, some businesses will publish accounts that overstate their profits (or understate their losses) by not including expense items such as rent (where, for example, they own the business premises), or by understating the realistic cost of running the business by not including full salaries for business owners and their families. This can be due to oversight, or an attempt to overstate the value of a business.

In summary, published profits could be different from real profits because: Owners mix their private and business financial transactions. Profit is shifted between different business entities within the same group. In any one year there are non-recurring, or ‘one-off’ items included in the accounts.

The real profit of a business should be used to arrive at a true value of a business, whatever profit-based valuation method is being used.