Estimate Your Business Value – Learn Three Valuation Methods
Discover three common business valuation methods: the asset approach, the market approach (multiples of earnings), and the income approach. Excerpted from BizBuySell's Guide to Selling Your Business.
Transcript:
Estimating the value of your business. in the same way that a medical checkup, assessing your current physical condition and provides information that guides your healthcare decisions, a business valuation assesses the current condition and value of your business and provides information that guides your business planning, exit planning, planning for pre-sale improvements, and sale timing decisions.
By estimating the value of your business, you will have the information you need to determine whether your business today meets the financial objectives you're aiming for in a sale and if not, to determine the extent of improvements required and the amount of time necessary to achieve them.
Three widely accepted valuation approaches lead to an estimate of business value which almost always is revised with professional assistance prior to finalizing the sale asking price.
The asset approach estimates the fair market value of the physical assets of a business that could be converted to cash. This assessment is especially important to owners of distressed businesses who are likely to liquidate tangible assets.
The market approach projects estimated value of a business based on sale prices of comparable businesses. It involves accessing and analyzing data from recent transactions and dividing sale prices by business revenues or earnings to arrive at the multiple at which the sales of comparable businesses have closed.
The income approach estimates the value of future business cash flows or income. It is especially important when valuing startups or turnarounds for which past financial performance is not a good indicator of future potential.
No one valuation approach answered the question, what's my business worth? Instead, a combination of approaches contributes to the answer based on the value of your business assets, sale prices of comparable businesses and the annual earnings and strength of your business as a going concern
The asset approach to valuation. This approach establishes the fair market or sale value of the tangible physical assets of your business. The asset valuation includes all physical assets of the business, including fixtures, furnishings, equipment, inventory, real estate, and other physical assets.
The asset valuation does not include the value of intangible assets, such as brand recognition and reputation, websites and online presence, client lists and relations, skilled workforce, trademarks, patents, and Trade Secrets and intellectual property that will transfer to a new owner. A valuation of assets is essential throughout the sale process.
If after completing a business valuation the sale value of physical assets is very similar to the price likely to be received through a business sale, liquidation, simply selling assets and closing shop becomes the most expedient exit route.
During business sale negotiations, the asset valuation substantiates a component of the
business pricing strategy. It presents an asset inventory and a sound projection of what it would cost the buyer to otherwise purchase the furnishings, fixtures, equipment, and other physical assets of your business in their current condition and at their current market value during the due diligence phase of a business sale.
The asset valuation confirms all assets being transferred and whether each asset is owned outright or financed, and whether specific assets are accompanied by service agreements or other obligations.
Conducting an asset valuation. Begin by listing all physical assets of your business. Make an inventory by going room by room, department by department, or location by location.
Or, group assets by type, such as office furniture, office equipment, production equipment, office furnishings, leasehold improvements, automobiles, and so on, also noting the location of each asset.
For each asset, record the date of acquisition, original cost, replacement cost, and current fair market value, which is the sale value of the asset in its current condition.
Use the asset valuation worksheet in the digital toolkit as you create and value your asset inventory
The form automatically calculates column entries it also includes a column for notes regarding ownership, such as the amount of the purchase price outstanding, the cost of accompanying service agreements, and other costs of ownership. Access the digital toolkit by visiting bizbuysell.com/seller/selling-a-business
Be aware that the resulting asset valuation will differ from the asset value shown on your business balance sheet for two reasons.
One, the balance sheet reflects the book value or carrying value of assets based on acquisition cost, minus depreciation, while the asset valuation reflects the fair market value of assets, which in some cases could be even more than their initial price.
Two, the balance sheet reflects the depreciated value only of assets acquired at prices above a minimum value, while the asset valuation includes the market value of all physical assets minus any liabilities associated with those assets. Also, be aware that there are situations that may require asset valuations by an independent certified appraiser.
The market approach to valuation. The market approach estimates the value of your business based on data from similarly sized and recently sold businesses in your geographic area or business sector.
It involves multiplying the earnings of your business by the valuation multiple at which similar businesses have sold or are selling accessing comparable data. Often referred to as comps, comparable data is usually sourced through online databases tracking recent listed and recently sold businesses. These databases are typically accessed through business brokers or professional appraisers. You can also access comparable data by visiting bizbuysell.com/business-valuation-report/
Comp criteria can be targeted by industry, geographic location, financial performance, sale price and other filters using comparable data. To establish valuation benchmarks, knowledge of the price to revenues or price to earnings ratios at which businesses similar to yours have recently closed provides a benchmark for the valuation multipliers you might use to arrive at a ballpark estimate of your business value.
The goal is to compare businesses like yours in terms of Industry classification, geographical location, size in terms of revenue assets, employee earnings, and other financial metrics.
Two of the most common ratios used are revenue multiples, often referred to as sales multiples, and earnings multiples.
Revenue multiples are based on the gross revenue shown on the annual business income statement. They involve a fixed figure and therefore, some experts feel applying a multiple to annual gross revenue is the most reliable approach.
However, because annual revenues cannot reflect how much money the business actually earns, most experts caution that basing the price multiple on revenues does not reflect the health of the business. Revenues do not reflect whether the business is mismanaged or if it has higher than average expenses.
Earnings multiples are based on how much the business earns annually for the benefit of its owner. Owner earnings differ from the annual profit shown on the business year-end income statement or its federal tax return. When pricing small businesses, profit and earnings are defined as follows.
Profit. The bottom line on the business income statement reflects all business revenue less all legally deductible business expenses to arrive at the lowest possible taxable income.
Annual owner earnings also called owner's cash flow or sellers discretionary earnings SDE also include all business revenue. But from there deductions reflected on the income statement are revised to arrive at a total showing how much the business actually generates for the benefit of its owner in a normal year.
Preparing a statement of seller’s discretionary earnings SDE. To calculate SDE, a key figure in small business sales, the year-end income statement is recast with the following adjustments.
One. Add back expenses that were deducted for interest, depreciation, taxes, and amortization, resulting in what accountants call business EBITA, earnings before interest depreciation taxes and amortization.
Two. Add back expenses that benefited the owner directly, such as owner's salary and benefits, insurance and auto use.
Three. Add back discretionary expenses and contributions or donations that another owner might choose not to incur.
Four. Add back nonrecurring expenses to normalize earnings by excluding unusual and one-time transactions of the business.
Five. If SDE has differed greatly over recent years, work with your accountant to create and present what is called a weighted average.
Six. To prepare an estimate of your SDE, use the SDE calculation worksheet in the digital toolkit working from your financial statements to fill in the shaded cells. The form automatically calculates entries to reflect your annual owner's benefit, your seller’s discretionary earnings or SDE, which forms the basis of the income-based valuation used in pricing nearly all small and medium-sized businesses.
Calculating the earnings multiple. The earnings multiple used in most small business valuations is a number between 1 and five. Businesses with weakest potential and highest risk have the lowest multiples and businesses with strongest potential and lowest risk have the highest multiples.
To determine the multiple for your business, begin by studying comparable data benchmarks described in the previous section, they provide the most basic ballpark estimates of earnings multiples for businesses matching your size, geographic location, or business sector.
You can begin to estimate the earnings multiple for your business by assessing factors likely to signal attractiveness or risk to buyers. To begin, open the earnings multiple assessment worksheet in the digital toolkit.
Consider the questions that accompany each factor and assign a number from 1 to five that you feel accurately reflects the condition of your business, with one indicating the weakest condition and five the strongest condition
The form automatically averages ratings to provide an early sense of the earnings multiple that your business in its current condition and based on your assessment might command.
Doing the math. This is the easy part of estimating value using the market approach. You have analyzed comparable sales data and learn the multiples achieved by recent sales of businesses similar to yours.
Based on market comps and your own assessment of the condition of your business, you have estimated the multiple to use when roughly estimating your business value.
You have recast your year-end income statement to arrive at your sell's discretionary earnings
SDE. You are now a simple calculation away from creating a ballpark estimate of the value of your business.
SDE times earnings multiple equals estimated business value. That single calculation results in the estimated value of your business.
The income approach to valuation. The income approach values a business based upon its expected future performance and cash flows, which are calculated by projecting current business earnings and then adjusting for changes in anticipated future growth, rates cost structure, and other factors that affect earnings.
The income valuation is based on either capitalization of earnings or discounted cash flow.
Capitalization of earnings measures the value of a business by determining the net present value NPV of expected future profits or cash flows. This involves dividing the expected future earnings of the business by the capitalization rate, which is the rate of return the buyer can expect to earn on the investment made to purchase the business.
The capitalization rate is determined in part by the company's perceived risks. This method is often used by businesses with stronger future growth and profit projections than past performance indicates.
Discounted cash flow DCF estimates the value of a business based on its projected future earnings. First the expected cash flow of the business is projected over a duration of time, usually one year. That projection is then discounted based on risk using a percentage, which is either derived from weighted average cost of capital WAC or whack or a buildup rate determined by the market.
Circumstances that alter the business valuation. Until the time of a sale offering, business valuation will be adjusted to account for changing conditions, including:
Changes affecting your business sector and market area may affect the value of your business and the price a buyer might be willing to pay for it.
Changes altering economic conditions may affect your sales volume and profit margins also affecting the annual earnings upon which multiple of earning valuations are based.
Departure of key personnel or major clients or other major business changes may affect business value and attractiveness.
Beyond adjustments, due to circumstances prior to a sale listing, the asking price will be further adjusted based on the following circumstances.
If the sale offering includes seller financing. The seller's willingness to accept a portion of the purchase price in payments that are not due until a defined point in the future, the attractiveness of the sale offering increases. Some studies show that by offering seller financing, the earnings multiple used in the price calculation can increase by as much as a third, resulting in higher business value.
Because business buyers negotiate downward from the business asking price, sale pricing is often set at 10 to 15% over valuation to account for the effect of buyer negotiation.
All valuation approaches and especially the income approach benefit from the knowledge and expertise of experienced professionals.
Seek guidance from a business appraiser or valuation expert if your business owns intellectual property or involves proprietary processes, a valuable brand or other assets that are unique and therefore difficult to value and price.
Seek guidance from business consultants if your selling price could be significantly higher following major business improvements that are beyond the expertise of you and your management team.
Seek guidance from a broker if you need help placing a value and price on your business, maintaining confidentiality about your sale, finding and dealing with prospective buyers, and taking on the demands of selling your business while you keep running it efficiently.
Seek guidance from a merger and acquisition M&A specialist or from an attorney with M&A expertise if your business has annual sales over $5 million or annual SDE over $1 million, as it is likely to attract another business as its buyer and the sale will be complex.
Seek guidance from a local Small Business Development Center SBDC for help with business planning, financial management, and much more.
Choosing a broker. Business brokers offer in-depth insights on valuation, marketing, prospecting, negotiations, and other fundamental sale elements. Most have extensive prior business experience that allows them to understand the financial operational and legal aspects of a business from sale preparation through the sale process.
Their role is to streamline the process, focusing on the deal while the owner focuses on maintaining business operations and strengths.
When seeking a qualified broker, check out the BizBuySell Broker Directory, the largest online broker directory, which includes thousands of professionals who can assist with business sales.