Valuing a business isn’t as straightforward as it might seem. While adding up assets and subtracting liabilities is a good start, there are enough variations between industries, marketplaces, and potential buyers to create a large gap between the low and high end of a potential valuation. There are many key things to keep in mind when calculating the value of your company.
“Your business is likely your largest asset so it’s normal to want to know what it is worth,” writes John Warrilow, a contributor at Inc. “The problem is business valuation is what I would call a ‘subjective science.'” An MBA will help guide you through the science of business valuation, but the subjective position of potential buyer is something that cannot be calculated in so straightforward a manner. Knowing the ins and outs of business valuation will help you determine an acceptable range of value for your business.
Knowing Your Business
“It is important to point out that the value of your business is largely determined by the industry in which you operate,” writes Mary Ellen Biery, a contributor at Forbes. She gives the example of coin laundromats, which are typically valued “at two or three times sales.” These formulas vary widely from industry to industry. As Warrilow points out, “accounting firms typically trade at one times gross recurring fees.”
These formulas are dependent not only on the going rates in a particular industry, but also the size of an individual business. “For example, a small medical device manufacturer might think that, because GE is trading for 20 times last year’s earnings on the New York Stock Exchange, they too are worth 20 times last year’s profit,” writes Warrilow. “However … a small medical device manufacturer is likely to trade closer to five times pre-tax profit.”
None of these industry standards are set in stone, however. This is where it is important to keep subjectivity in mind; prospective buyers will determine how much they are willing to pay based on their own criteria that you may not be privy to. While one buyer may offer the typical going rate of a business in your industry, another “may decide your business is strategic, in which case back up the Brink’s truck because you’re about to get handsomely rewarded,” says Warrilow.
Valuing Hard Assets
The most straightforward starting point for valuing your business is a simple assets-based calculation. “Imagine a landscaping company with trucks and gardening equipment,” writes Warrilow. “These hard assets have value, which can be calculated by estimating the resale value of your equipment.” While this is a solid starting point, it is important to keep in mind that this valuation technique is a low-end estimate of the worth of your business.
This basic formula does not account for goodwill, which is the gap between a basic assets-driven valuation and the market rate for your business. “Typically,” writes Warrilow, “companies have at least some goodwill.” Other formulas are needed to calculate a valuation on the high end.
Discounted Cash Flow
The discounted cash flow method is a much more nuanced method for valuing your business. According to Biery, the basic method is to “derive the value of the business by forecasting the future positive cash flow that the business will generate, then applying a discount to that forecast based on the time value of money.” The time value of money is another way of accounting for the diminishing value of the dollar over time, i.e. inflation.
“The more stable and predictable your cash flows, the more years of future cash they will consider,” writes Warrilow. If your business has a relatively reliable income, it will likely be worth more to a prospective buyer. Similarly, if the income of your business is erratic, it will likely be valued at a lower rate.
According to Biery, the discounted cash flow method is “the best method of valuation for any asset, because it calculates the ‘intrinsic value of a business’ and gives you a strong point of reference.” When negotiating with a potential buyer, it will be important to know both the high- and low-end valuations of your business.
Valuing an Existing Business
If you find yourself on the buyer end of the equation, there are some things to keep in mind that do not apply to the seller’s end. Jeff White, a contributor at FitSmallBusiness.com, says, “Most experts agree that the starting point for valuing a small business is to normalize … the business’s earnings to get a number called the Seller’s Discretionary Earnings (SDE).” The SDE is “the pre-tax earnings of the business before non-cash expenses, owner’s compensation, interest expense and income, or one-time expenses that aren’t expected to continue.”
This means that, as a buyer, you must account for business expenses like nonessential travel, personal vehicles filed as a business expense and donations. Things like this should be added back into calculating the business’s net income.
Whether you’re on the buying or selling end of the market, it’s important to be able to accurately value your business or others’.
Learn more about the University of West Florida’s online MBA with an emphasis in Entrepreneurship program.
Sources:
Forbes: How to Know What Your Business Is Worth
Inc.: How to Value Your Business
Entrepreneur: How to Value a Business?
FitSmallBusiness.com: How to Value a Business: The Ultimate Guide to Business Valuation
