6 Rules of Thumb for Business Valuation
When it comes time to buy or sell a business, it’s important to set your personal feelings aside in order to do an accurate business valuation and establish a realistic and competitive selling price. You’ll need to objectively analyze the business, study the current market, and consider employing the expertise of a professional business appraiser.
There are three common, acceptable business valuation methods. One may be more suitable than another, depending on the type of business being valued, including its industry, size, and circumstances of sale.
- Income Based Business Valuation Approach
- Asset Based Business Valuation
- Market Based Business Valuation
An income business valuation approach is a type of valuation based on projected future cash flow or earnings. It is recommended for businesses that have a large potential for growth. Entrepreneurs looking to purchase a business are doing so to make money. So, the largest factor a potential buyer will consider is the amount of money they stand to make in the future. There are two variants of this approach, capitalization of earnings and discounted cash flow (DCF).
With the capitalization of earnings method, the historical cash flow of a company is divided by its capitalization rate. A capitalization rate is expressed as a percentage and represents the rate of return on the capital including equity components and debt. This method helps to identify risks and quantify the potential return on investment. By using the net present value of cash flows from existing agreements or expected profits generated through ordinary course of business and adjusting for risk, this calculation is especially useful for valuing service-oriented businesses.
The discounted cash flow method takes the company’s projected cash flow and then discounts that amount for risk using the weighted average cost of capital. This projection is usually calculated for one year and then assumes perpetual and constant growth. Because of that assumption, this method of valuation is best used when an analyst is confident about the assumptions being made.
An asset-based business valuation focuses on the book value of a business and deducts liabilities. It is often used in conjunction with other methods of valuation and may be required as part of the due diligence process for private companies. Be sure to include not just the machinery and furniture of your business but also intangible assets such as patents, trade secrets, and trademarks. Measuring intangible resources is complicated because it requires accuracy, attention to detail, and experience.
A market-based business valuation is one of the simpler business valuation methods. By comparing your business to similar ones that have been sold recently, you can determine the value of your business. You will want to find companies with similar financials within your sector and then calculate the average of trading multiples (how the company operates). The multiples frequently used in this approach are return on equity, price to earnings, enterprise value (EBITDA), price to book value, and return on assets.
Now that you have a sense of the different ways in which you can value your business, let’s discuss the rules of thumb. These tips will help you calculate the best price before putting your business up for sale.
1. Prepare the financial statements and determine the SDE.
The first rule of thumb for business valuation is preparing the company’s financial statements. The owner should gather the financial records for the past three years including: an income statement, a cash flow statement and a balance sheet. If the business hasn't been operating for three years, consider using a projection model.
Next, work with an accountant to transform the income statement into a seller’s discretionary earnings (SDE) statement, which considers non-recurring purchases and discretionary expenses to more accurately reflect the value of your business. SDE gives you a better idea of the true profit of your business because it includes expenses that aren’t required to run the business. These expenses include your salary (and the salary of any additional owners), travel that’s not essential to the business, relatives that have non-essential positions, charitable donations, leisure activities, and one-time expenses like settling a lawsuit.
2. Establish the asset value of the business.
The second rule of thumb for business valuation is to establish the asset value of the business. First, estimate the value of the company’s tangible assets by taking inventory of all the physical aspects of the business such as fixtures, equipment and inventory. Real estate, cash on hand, and accounts receivable are also included.
Next, estimate the value of the company’s intangible assets, including intellectual property, contracts, partnerships, brand recognition, and more. Assigning value to intangible assets can be tricky and it may be best to consult with a business broker or professional appraiser.
While asset valuation gives you a clearer picture of the business’s current value, it fails to clearly reflect the value of the company’s earning potential. Since buyers are primarily interested in their investment’s future earnings, it’s a good idea to quantify an estimate of the company’s earning potential through price multiples.
3. Use price multiples to estimate the value of the business.
Another valuation rule of thumb is using price multiples, which base the value of the business on a multiple of its potential earnings. Price multiples provide buyers with a tool to estimate their return on investment. They are a quick way to arrive at a general estimate of the business’s sale price.
Once you’ve established the asset valuation of the business, the next step is to determine the multiple that applies to the geographical region and type of industry. These numbers combine to form an equation that results in a fair estimate of the business’s sale price.
For example, nationally the average business sells for around 0.6 times its annual revenue. Once you’ve determined the annual revenue and found the correct multiplier, it becomes a simple matter of plugging the numbers in and then doing the math. The trick is to find the right multiplier for the business, since they can vary quite a bit.
Some of the factors that add to the variance we’ve already reviewed such as assets and SDE. Future prospects of the business should also be taken into account. For example, if an industry is experiencing a boom and popularity is growing, that would increase your multiplier. However, if the business does not offer seller financing, the multiplier may decrease.
Also, a change in ownership can mean changes in supplier relationships. Customers who were once loyal to an owner may start going elsewhere. These types of issues are called “owner risk.” If an existing business has a great deal of owner risk, it may not survive a transition to a new owner. Those risks can negatively impact the overall value of a business.
4. Use comparable (or comps) of ‘For Sale’ and sold businesses.
Recent sales of comparable businesses (or ‘comps’) are a popular valuation rule of thumb that will offer you a realistic picture of what similar businesses are selling for. By identifying examples of similar businesses that have sold in the same area, you can get a better sense of a realistic selling price.
Comp data can be accessed through several online sources, as well as through business brokers, who can help to provide you with the right multiplier for your market. BizBuySell provides an inventory of over hundreds of thousands of successfully sold businesses and over 50,000 businesses listed for sale. You can narrow your search by industry and geographic location, and then narrow it further by gross income and cash flow.
5. Improve the value of the business.
If an owner is disappointed when they discover the estimated value of the business, there are many ways to improve it. In fact, the sooner the owner begins working on increasing the business’s selling price the better. Remember that buyers are interested in businesses that offer the greatest potential for future profit. Documentation of several years of profit growth will add value to the company.
Buyers are looking for an easy transition into their new business, so evidence that the business is well-organized and running smoothly will also add to the company’s value. A clean and well-oiled machine with a neat, organized package of detailed financial records, compliance with health and safety regulations, renewable leases, employee policies, staff with transferable contracts, supplier lists and an established client base will go a long way. Potential buyers will be impressed and more likely to feel the business is a good investment for them.
Seller financing is yet another way that owners can potentially improve the value of a business. Partially financing the sale can benefit the owner with a higher selling price, collected interest, and a wider field of potential buyers.
6. Consult with a professional appraiser and get a formal valuation.
Hiring a professional business appraiser not only allows you to benefit from his or her expertise, it provides the objectivity that you may lack when it comes to making a fair assessment of the business. Many brokers are experienced at conducting a formal valuation or have connections with qualified professionals. A qualified professional should have the designation of Accredited in Business Valuation (ABV). Accountants who have earned this certification are required to pass an exam administered by the American Institute of Certified Public Accountants (AICPA). In addition to the exam, these specialists must meet business experience and education requirements to be certified.
Valuing a business correctly is essential in a competitive market, and enlisting the help of a third-party professional will not only eliminate seller sentiment from the sales process, it will also shorten it by aligning the business value with up-to-date market conditions.
As you can see, valuing a business requires a multilayered approach. Oftentimes, owners with an intent to sell will combine more than one business valuation method to gain a very accurate appraisal. Most small businesses start with an SDE and add more analysis based on sales, cash flow, and liability. All these factors combined will give you an accurate business valuation.
It’s important to strive for accuracy when coming up with that target number to list your business for sale. When priced incorrectly, you run the risk of selling your business for less than it is worth. Or, on the flip side, you might scare off investors by pricing the business too high. It is always best to get advice from experts if you have the time and resources to do so. However, valuing the business yourself is most likely the quickest way to complete the process.