If you are looking to sell your business, buy a business, raise equity funding, or simply know what your business is worth, it is important to know the different business valuation methods. There are many pieces that go into the business valuation, and it is important to understand everything that is included in this complex calculation before setting a price or making a bid.
Here at CFOshare, we perform company valuations on small businesses between $0 and $50M in revenue. You can book an appointment here if you want a professional valuation now, but if you are just curious about business valuation methods, read on.
Business Valuation Methods
There are three primary ways to value a company:
Market Based Approach-
The company valuation is derived from what others are willing to pay for similar businesses. Comparable transactions are studied to calculate this valuation.
Income Based Approach-
The company value is derived from its ability to generate cash. Historic performance is studied, future cash generation is projected and discounted to a present value.
Asset Based Approach-
The value of the company is its assets minus liabilities. This approach is most appropriate in liquidations or when intellectual property is unusually valuable.
Early stage startup businesses require an entirely different set of business valuation methods due to their immaturity. What is used to value a mature company doesn’t work for a business just starting out.
Company valuation is not a simple or straightforward task and should generally be performed by a professional specializing in such valuations. While one of the aforementioned calculations may be the most appropriate for your company or the company you are looking to acquire most of the time, each calculation will be done and a value will be reached based on these and other factors.
Market Based Business Valuation
This is the most popular business valuation method. Unlike mathematically rigorous valuations like discounted cash flow, market-based valuations are easy to calculate. The company value is based on recent purchases and sales of comparable companies in the same industry as the company you are valuing. But where do you get this data? For small businesses, these values are usually only available in subscription databases which are prohibitively expensive. That’s why most entrepreneurs hire valuation companies to save money.
If you are a rapid growth company such as SaaS or tech, you will probably be valued based on a multiple of revenue. This is usually the highest and most favorable business valuation. Service businesses whose sole value is the book of business will also be sold as multiples of revenue (albeit much lower multiples than SaaS.)
Most company valuations are based on Earnings Before Interest, Taxes, Depreciation, and Amortization. This is a calculation to approximate cash from operations without the influence of ownership structure. EBITDA is not a GAAP metric on the income statement, and usually contains discretionary adjustments besides those listed in the acronym – proper diligence when calculating EBITDA is critical!
Lifestyle Businesses Valuations
Seller’s Discretionary Earnings, or SDE, is used to determine the income potential for business owners of closely held LLC’s. SDE is a value that serves the same purpose as EBITDA but is specifically useful for valuing lifestyle businesses.
This figure is the pre-tax earnings of the business before owner’s compensation, non-cash expenses, interest expense and income, and one-time non-recurring expenses. The owner’s compensation is included in this calculation, while it is not included in EBITDA, because it is assumed that the buyer will replace the owner.
The company valuation will be a multiple of SDE (similar to EBITDA.) The multiple is dependent upon your industry, and varies based on location, tangible and intangible assets, company size, and market characteristics and volatility.
Owner risk also plays a role in determining your specific multiplier. This means that if the business will lose value as a result of the owner leaving, you will discount the business value. Asset value can also play a factor, depending on the industry and deal structure.
Income Based Business Valuation Method: Discounted Cash Flow
Income based valuation methods treat business investments like financial portfolio holdings to calculate their value. Mathematically it is highly defendable, but the company value is highly dependent on your projected cash flow. How do you accurately estimate future cash flow? That is the key question professionals focus on when performing income-based business valuations.
Discounted Cash Flow (DCF) is the most well-known income-based business valuation method. DCF projects future cash flows and discounts those based on risk and opportunity cost, after which the present value is calculated. A proper discounted cash flow analysis will consider your historic cash flow, industry changes, business-specific risks, and macro-economic financial factors.
Discounted cash flow has two major drawbacks:
- Discounted cash flow is highly dependent on exit assumptions (known as terminal value assumptions.)
- Growth rate assumptions are largely subjective and difficult to substantiate
Asset Based Business Valuation Method
If your business is facing immediate liquidation due to distress or the owner’s desire for a quick exit, the asset-based approach is most appropriate. In this method, the business’ total assets less total liabilities determine the company valuation. Note: this is not always as straightforward as looking at the balance sheet due to differences between book value and market value of goods. For example, a vehicle may be depreciated down to a $2,000 value on the books but be worth quite a bit more if sold to a dealer.
Asset based business valuations are also useful if intellectual property is disproportionately valuable in the company, such as with an early-stage pharmaceutical or medical device business.
Other Things to Note
When you are looking to determine the value of your business, knowing the valuation methods is important, but there are some other important things to consider.
For Sellers: Organize Your Finances
You may want a business valuation because you intend to sell your business. If so, remember your business valuation will only be as good as the quality of your financial information. For small businesses that have recently undergone a growth spurt or distress, getting finances in order can be a daunting task. Important documents and information to have on hand include:
- Detailed annual financial statements
- Profit/Loss statements
- Balance sheets
- Statement of cash flows
- Supporting schedules for all balance sheet accounts
- Tax filing paperwork and returns
- Financial forecasts
- Receipts and deeds pertaining to assets
- Copies of any existing contracts and leases
- Ownership paperwork
Check in with your bookkeeper to make sure your books are up to date (side note: if you think your bookkeeper is under-performing, you are probably right. Bring in an outsider for an objective evaluation.) The better quality your financial reporting and support, the more accurate your business valuation.
For Buyers: Perform Due Diligence
Buyers must do their homework when it comes to company valuation, and no buyer should just go in trusting 100% of what they are being told. Even the most trustworthy of business owners may see their business as worth more than it is, or overvalue things for a variety of reasons.
“Buyer beware” is especially important when purchasing a small business, and buyers need to look out for a variety of red flags. The existence of one or two issues does not necessarily mean the whole conversation should be halted, but if issues are not being discussed, or if many issues arise, there may be cause for concern.
- Are the financials consistent with Generally Accepted Accounting Principles?
- Is there unusual balance sheet activity, such as growing asset accounts or shrinking liabilities?
- Is the owner acknowledging industry risks, or are they downplaying known issues?
- Have all liabilities been properly accounted for?
- Is the company value highly dependent on the owner?
- Does the business’s wellbeing hinge on one or two large customers?
- Are there contracts in place or might these customers leave with the sale?
Final Thoughts on Business Valuation
Company valuation is both an art and a science – it takes a great deal of information and skill to do well. As a buyer or a seller, it is important to have all of your ducks in a row, as either undervaluing or overvaluing the business could lead to problems with the sale.
Valuing a company is not for amateurs. At CFOshare, we can provide guidance through every step of the business valuation. Book an appointment now with a CFO to help ensure your business valuation is accurate and your transaction successful.