How to Determine the Value of a Business
Determining the value of a business for sale is complex, and there are many ways a business can be valued. Some valuation methods work better for different types of businesses. This article discusses ways you can informally determine the value of your business that you are considering selling.
Even if you get a formal business valuation from an appraiser, knowing the different valuation methods can help you sort out what's going on.
Ways to Determine the Value of a Business
These valuation methods are presented to give you some ways to explore your own business worth and to get a general idea of where to start a negotiation between yourself as a seller and a potential buyer. Don't assume that any, or all, of these valuation methods, will give you a true number, but they are a start at a valuation. In some businesses, you might end up using all of these business valuation methods.
Your business assets are all the things the business owns that has a value and can be shown on the balance sheet. Assets include land and building, equipment and vehicles, cash, supplies, accounts receivable. Intangible assets like intellectual property also have a value. Usually asset valuation looks at the total cost required to create another business with the same assets.
Business assets can be valued in two circumstances: as a going concern (a business operating as usual) or as liquidation, a sell-off of assets for cash. The liquidation value of assets (in business bankruptcy, for example) is much less than the value of these assets as part of a business in operation
If you are selling the entire business based on asset valuation, you will only have part of the business valuation picture. The mystery factor in any business valuation is goodwill. Goodwill is basically the intangible value of your business based on a variety of factors, including
- Name recognition
- Customer loyalty
- Trademarks and trade name
- Skilled employees
- Specialized know-how
From an accounting standpoint is the premium paid for the business over the book value of the listed assets on the business balance sheet.
Some buyers want to know how much cash your business can generate. This method uses information from a cash flow statement showing the inflows and outflows of cash for the business over a specific time period. Then this current cash flow number is discounted for its future value. Cash flow value is often used for valuing companies that have shareholders.
Multiples of gross sales, as Entrepreneur says, are the "crudest approximation" of business valuation. For example, gross sales for the three previous years might be used. But there is no guarantee that this level of sales can be supported, which is why it is less useful for valuation on its own.
Multiples of Earnings
For businesses that have shareholders, looking at multiples of earnings per share of stock is a common valuation method. Earnings valuation is based on the business's ability to produce future wealth. This number shows the earnings of each shareholder, or EPS, which is not the same as any dividends. The principle here is that the higher the EPS, the more valuable the company; earnings valua
Here's how the earnings method works: First earnings (otherwise known as profits or net income) are determined. Most often, the "raw" earnings number is reduced further, usually by taking out interest and taxes (called EBIT or Earnings Before Interest and Taxes). Another common measure is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Then the final earnings number is multiplied by the number of shares.
Seller's Discretionary Earnings (SDE)
The seller's discretionary earnings valuation method is similar to multiples of earnings, but it's used for small companies in which there is one owner, like a professional practice or sole proprietorship. In this method, the gross profit is reduced by several numbers so that earnings can be determined just on operating expenses:
- Income taxes
- Nonrecurring income and expenses
- Non-operating income and expenses
- Depreciation and amortization
- Interest expense or income
Valuation is usually expressed as a multiple of SDE, from one to four times. The multiple depends on the type of business. Some common multipliers are the age of the business, risk, location /facilities, competition, the industry.
SDE and Owner Compensation
Seller's discretionary earnings may or may not include the owner's compensation, depending on who is doing the calcultion. The International Business Broker's Assn. says that discretionary earnings exclude "one owner's entire compensation, including benefits and any non-business or personal expenses paid by the business.
The Colorado Small Business Development Corporation says SDC includes the owner's salary, while EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) doesn't include the owner's salary.
Why Business Valuation Methods Are (Mostly) Not Accurate
This article presents some ways to value a business, but the only true valuation is the one agreed upon by the buyer and the seller, after negotiation and full information. The more valuation methods you use, the closer you might get to a number. The more numbers you can gather, the better your estimate.
Most business valuations are unrealistic because they don't consider outside or intangible factors. Here are some examples of other factors in determining business valuation.
The condition of the U.S economy affects all businesses in many ways, and local economies may have an even greater effect on your business. Consider economic factors in your expectation of the value of your business to a prospective buyer.
Location and Market Factors
Business sales, like real estate sales, are all about "location, location, location." As you evaluate your business selling price, keep in mind the location factors going out from your immediate business neighborhood to your city and county, to your state.
It's difficult to place a value on the level of technology used by a company, but it's a huge factor in the sale of a business. Your business website, any online selling you do, and the use of computer programs and apps in all sections of your business can have a positive - or negative - effect on a buyer.
A Final Note on Business Valuation
The determination of the value of a business is, in the end, only realized when a willing buyer and willing seller sit down and come to an agreement, and put that agreement in writing. But having some business valuation methods in your pocket when you go into a negotiation with a seller can help you focus the discussion and get to an agreement more easily.