How to Value a Business
One of the most stressful parts of selling your business is deciding how much to list it for. It’s impossible to put a price tag on a business without knowing the value. Beyond deciding how much to sell your company for, knowing the value may even help you determine if selling is the right decision. How do you get started learning the value of your business? Let’s take a look at the different options and approaches available to sellers and how to effectively utilize the information.
Business Appraisals vs. Estimated Valuations
There are two primary ways of obtaining your business value: business appraisals and estimated valuations. While they both provide accurate information about the value of your business, which method is best is dependent on your situation.
Business Appraisals
A full business appraisal is the highest standard in valuing a company. Business appraisals are typically required for legal purposes such as tax issues, divorce settlements, bankruptcy, or repurchasing corporate stock. Because a business appraisal is used as the standard for these types of situations, this type of report is certified as an official business appraisal. A full business appraisal may involve an on-site visit to confirm that physical assets match what is on the books.
Unless you’re in a special situation where a business appraisal is required, it’s not likely the best resource for someone who is hoping to sell their business. The cost could start around $5,000, which is a sizable investment for any small business owner.
Estimated Business Valuations
While estimated business valuations cannot be used for legal purposes, they can be a good starting point for business owners who are planning to sell their company. Depending on who prepares the report, an estimated business valuation can look different and provide varied information. In general, the analysis provided is similar to an appraisal except much shorter. This means that an estimated business valuation is heavily dependent on the financials provided by the business owner
The cost of an estimated business valuation can be much lower than an appraisal. While business appraisals are a significant monetary investment, a quality estimated business valuation should cost less than $1,000. The process is also less invasive and much faster — rather than having someone on site at your company, the valuation is calculated based on the financial information you provide. With that in mind, if you want an accurate valuation, it’s extremely important to provide accurate financial and bookkeeping data.
Valuation Approaches
Quality estimated business valuations should include multiple approaches and methods as a part of the analysis. Multiple analyses provide a more complete picture of your company’s value, and depending on the information you provide or the nature of your business, one approach may make more sense than the others.
Required Financial Information
The first step in estimating the value of your business is providing all required financial data. It’s typical to be asked to provide information for the previous two years as well as projections for the current fiscal year. Here’s a list of the financial data you may need to provide based on your income, assets, liabilities, and growth.
Income
- Revenue: The amount of money received during the time frame.
- Pre-tax Income: Also known as Net Operating Income.
- Officer Compensation: The amount you were paid.
- Interest Expense: Interest (only) payable on any business loans.
- Non-Cash Expenses: Depreciation and amortization of your fixed assets.
- One-time Expenses/Losses: A one-time substantial loss, such as a disaster.
- One-time Revenues/Gains: A one-time substantial gain, such as a tax refund.
Assets
- Cash: The amount of cash recorded as an asset.
- Accounts Receivable: Cash balance owed to your company.
- Inventory: Cost of products or goods waiting to be sold.
- Other Current Assets: All assets that can be turned into cash within the year.
- Fixed Assets: Long-term tangible property owned by the business.
- Intangible Assets: Non-physical items of value such as email databases.
Liabilities
- Accounts Payable: Amount owed on goods or services purchased by the company.
- Other Short-term Liabilities: Any obligations not included in accounts payable that will be paid out within one year.
- Bank Loans: Any bank loans that will be paid for longer than one year.
- Other Long-term Liabilities: Obligations to be paid for longer than one year such as pension liabilities or deferred tax payments — atypical for small businesses.
- Contingent Liabilities: A liability that is expected to occur in the future such as a pending lawsuit.
Growth
- Projected Revenue Growth: Expressed as a percentage based on historical growth rates.
- Opportunities for growth.
- Information about what makes your business unique and why you’re selling it.
Asset Approach
Using your company’s balance sheet, the asset approach calculates the value of the business’s assets less the value of the liabilities. The asset approach doesn’t take cash, accounts receivable, or accounts payable into consideration because in an asset sale, the inventory and supplies change ownership, while the seller keeps the debt.
It’s important to keep in mind that the asset approach does not include intangible assets such as technology and vendor partnerships. If intangible assets represent a significant portion of your business, this approach may not be the best fit for you.
Using an asset approach valuation may make the most sense when assets make up a significant portion of the company’s value — commonly seen in early stage start-ups.
Discounted Cash Flow Method
The Discounted Cash Flow (DCF) Method utilizes your three-year forecast to estimate the business’s future cash flow. Also calculated over the same period is the EBIDTA (earnings before interest, depreciation, tax and amortization), which is calculated by adding non-cash depreciation and debt back into the company’s operating income. With the future value calculated, a discount rate is applied to the future cash flow, and the result is the current value of the company. The discount rate, which is widely used today, is intended to level the future value of money with today’s value.
Companies with a reliable financial history and reasonable confidence in their business’s projected forecast are good candidates for the DCF method.
Capitalization of Earnings Method
Like the DCF method, the Capitalization of Earnings (COE) valuation method uses income projections to estimate future cash. However, rather than using the discount rate, COE uses the capitalization rate, which is identified by subtracting the estimated future growth rate of the business from the discount rate. Though both DCF and COE methods rely on discount rates, which stem from the Ibbotson Build-Up Method, the two discount rates are not the same.
The COE method measures the amount of risk a buyer is taking on by identifying a rate of return required to make the business purchase a good investment. This method is more commonly used with companies that have been operating for three or more years. The longer the company has been operating the more accurate the information.
Market Approach
The Market Approach utilizes the value of similar businesses and assumes they are worth a similar amount. To account for variables such as company size, a specific industry multiplier is applied to a value factor, such as revenue. This calculation produces a market value, which is then adjusted to include asset value.
Any business can use the Market Approach as a helpful comparison when analyzing the values presented by other approaches and as a pricing estimate.
EBITDA Approach
The EBITDA Multiple Approach is a less commonly used approach and provides what is considered the ‘value ceiling’ for the company. To determine a company’s high-end value, the business’s EBITDA is multiplied by a factor, which ranges from zero to four based on the business’s life cycle stage and industry revenue volatility.
The value determined by the EBITDA approach is useful for franchisors and business service providers as a simplistic rule-of-thumb approach.
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