How to Value a Business: a Step-by-Step Valuation Guide



by

Having worked hard at building your business you are naturally interested in its value when the time comes to sell. Particularly if it's been well-managed with a good trading history and a loyal, profitable customer base.

So how do you value your business?

A number of business valuation methods are in common usage. Here are just a few.

  • Asset-based, or "book value" assessment. This method draws information from the balance sheet, so it's highly factual, looking at the here and now. But if yours is an ongoing business, assets in the balance sheet can be expected to generate profits into the foreseeable future and beyond. Therefore used on its own this method is likely to be detrimental to your interests as it ignores future cash flows. Indeed the book value method is often associated with a business that has failed, in a "fire sale" break-up valuation.
  • Stock market. Great, if your business happens to be listed in a competitive, openly-traded stock market where a share price reflects demand and supply at a moment in time. It's unlikely to apply to you.
  • Multiplies. There are a number of subjective "rules of thumb" based on multiples of, for example, profit, Earnings Before Interest and Tax (EBIT), Earnings Before interest, Tax, Depreciation and Amortisation (EBITDA), even sales revenue. However these can be seen as wild guesses and are difficult to defend objectively in front of a serious buyer.

So how do you calculate your business objectively, in a way that can be defended?

Related: Online Business Valuation Tool

Discounted Cash Flow (DCF)

The DCF-method is as accurate as it gets, looking at your business as an ongoing money-making machine. Current and future profits are what really interests a potential buyer. The less risky, the better. Looked at in this way balance sheet assets, for example fixed assets, current assets and money in the bank, are simply a means to this profitable end.

ad placement, do not delete

Having established that true business value is inextricably linked to future profits, we now take a look at the key elements of the DCF-method. We develop this explanation using the example of a mature, well-managed business, with a solid client base, forecast to earn $100,000 in profit every year for the next 5 years.

Forecast period

It's typical for business owners to make planning forecasts 3-5 years ahead. When you come to sell however there's an additional dimension to forecasting. That's the income accruing beyond this time horizon. There's more on this below, but for now let’s stick to a 5 year forecast period.

Adjusted profit explained

We need to be careful before taking the $100,000 profit figure directly from the income statement. Seller’s Discretionary Earnings (SDE) is a cash outflow of discretionary expenditure that is not part of normal business operations. For example, small business owners tend to pay themselves a salary above, or below the market rate. Equally it could be other optional perks or fringe benefits, for example company cars. For business valuation purposes it makes sense to adjust the profit to reflect the SDE (if any).

Now let’s feed the numbers into DCF. Below is the first version of our Business Valuation model.

Table 1. Version 1 of the Valuation Model

Year 1

Year 2

Year 3

Year 4

Year 5

Profit

$100,000

$100,000

$100,000

$100,000

$100,000

Total Profit

$500,000





Five years of profit at $100,000 suggests a business value of $500,000. Agreed?

But wait a minute. Is the buying power of money today the same as in 5 years time?

Intuitively (and correctly) the answer is, No. Because of the so called "time value of money".

Inflation reduces the value of a dollar over time. There's another more subtle reason based on the concept of "opportunity cost". In other words a buyer could have taken their money and earned guaranteed interest income, for example from government bonds. Or invested in shares of solid blue chip companies on the stock markets. Less risk, as compared with acquiring your business.

So it's clear for these reasons that $100,000 earned in 5 years is not worth the same amount today. But how is the adjustment made over the forecast period?

Say hello to "discounting"

Discounting is a technique that calculates the "present value" of forecast money received in the future.

ad placement (google), do not delete

In our example, each yearly profit number is adjusted using a standard formula to bring it back to today's money. There's no need for you to be a math genius here. Just know the formula for calculating the present value of an amount received in the future as:

Present Value = Amount / (1+Discount Rate)^Period Number

So, for example, the present value of $100,000 earned in Year 5 is:

Present Value = $100,000 / (1+15%)^5 = $49,718

(Where ^ is "to the power of", or the number of times the bracketed figure is multiplied by itself, which, you will note, has the effect of dividing $100,000 by a larger figure as each year passes, so progressively reducing its value)

But wait. Why the 15% discount rate?

The discount rate

The discount rate chosen reflects an assessment of relative business and financial risk. An appropriate discount rate is typically derived from two factors: 1) the so called "risk-free" rate of return (as, in theory, enjoyed with government securities), and 2) a selected risk premium for investing in a commercial business entity.

In our example, we analyze a business in terms of this Cost of (Owners) Equity.

What is Cost of Equity?

Cost of Equity is the expected return a buyer requires when putting money into a business. For mature businesses, this rate should be somewhere between 12% to 20%. The riskier the business, and the more uncertain the future, the higher the rate used.

For calibration, a start-up company's Cost of Equity could exceed 100%, whilst a utility company enjoying a near monopoly in a local market, may have a Cost of Equity as low as 5%.

For our example business, Cost of Equity is taken as 15%. 

Let's now take another look at how this affects the valuation table:

Table 2. Version 2 of the Business Valuation Model

Year 1

Year 2

Year 3

Year 4

Year 5

Profit

$100,000

$100,000

$100,000

$100,000

$100,000

Present Value of Profit*

$86,957

$75,614

$65,752

$57,175

$49,718

Total Present Value of Profit

$335,216





*Discounted at 15% discount rate






The Total Present Value of Profit in Table 2 above is now much closer to an accurate business valuation.

Can we stop here?

Probably not. Returning to the question of how to account for income beyond Year 5, we introduce the concept of Terminal Value.

Terminal Value

Sometimes referred to as Residual Value, Terminal Value represents the stream of cash generated beyond our 5-year forecast horizon. It's an assumption that steady cash flow will continue 5 more years (in theory, perpetuity shall be considered, but in reality nobody will accept that ;). The estimate takes the Year 5 cash flow and calculates present value of 5-years ordinary annuity:

$100,000 * ((1-(1/(1+15%)^5))/15%) = $335,216

Then, the math to calculate today's present value of the Terminal Value: 

$335,216 / (1+ 15%)^5 = $166,661

Now adding the "Terminal Value" to our valuation model:

Table 3. Version 3 of the Valuation Model

Year 1

Year 2

Year 3

Year 4

Year 5


Profit

$100,000

$100,000

$100,000

$100,000

$100,000


Present Value of Profit

$86,957

$75,614

$65,752

$57,175

$49,718

+

Total Present Value of Profit

$335,216






Terminal Value





$335,216

+

Present Value of Terminal Value

$166,661


Business Value

$501,877





So far, so good. A step closer to a realistic Business Valuation. Good enough?

Maybe.

  • Yes, if the business has no depreciated assets, no balance sheet debt, no intention to borrow, and no need for future working capital adjustment
  • Otherwise, No. We need to make a few future profit adjustments to arrive at "Free Cash Flow to Equity" (FCFE). That is, cash flows at the owner(s) disposal.

Let’s get started with some adjustments.

1st adjustment, Depreciation

Whilst business valuation doesn't directly take assets into consideration, any asset depreciation deducted in the income statement needs to be added back. That's because depreciation is an artificial, notional expense that doesn't see any actual outflow of cash from the business. It sets aside money, protecting it from corporate income tax. 

Let’s assume depreciation at $20,000 per year for the forecast period:

Table 4. Version 4 of the Valuation's Financial Model

Year 1

Year 2

Year 3

Year 4

Year 5

Profit

$100,000

$100,000

$100,000

$100,000

$100,000

Depreciation

$20,000

$20,000

$20,000

$20,000

$20,000

Free Cash Flow to Equity (FCFE)

$120,000

$120,000

$120,000

$120,000

$120,000

Present Value of FCFE

$104,348

$90,737

$78,902

$68,610

$59,661

Total Present Value of FCFE

$402,259





Terminal Value





$402,259

Present Value of Terminal Value

$199,994

Business Value

$602,253





Notice that Free Cash Flow to Equity (FCFE) sees the depreciation row added to the profit row, which is then discounted in the normal way. Terminal value is now also taken as the perpetuity of FCFE in Year 5 (instead of Profit in Year 5).

2nd adjustment, Changes in Working Capital

A company may adjust its working capital requirement. When perhaps it needs to increase inventory to meet rising demand, or improve liquidity through more cash-in-hand. Anticipated changes in working capital become cash flows, "in" or "out", depending on the direction of change in working capital.

In our example let’s assume that the company needs to increase its inventory level to $50,000 in Year 2. Increasing inventory makes the change in working capital figure negative as money flows out of the business.

Here's the new version of our valuation sheet.

Table 5. Version 5 of the Business Valuation Model

Year 1

Year 2

Year 3

Year 4

Year 5


Profit

$100,000

$100,000

$100,000

$100,000

$100,000


Depreciation

$20,000

$20,000

$20,000

$20,000

$20,000

Changes in Working Capital

$0

-$50,000

$0

$0

$0


Free Cash Flow to Equity (FCFE)

$120,000

$70,000

$120,000

$120,000

$120,000


Present Value of FCFE

$104,348

$52,930

$78,902

$68,610

$59,661

+

Total Present Value of FCFE

$364,451






Terminal Value





$402,259

+

Present Value of Terminal Value

$199,994


Business Value

$564,445





3rd adjustment, Borrowing

Borrowing means taking out loans and paying them back. This cash flow is completely under the control of business owners. Logically, loan repayments decrease the amount of Free Cash Flow to Equity, and vice versa. In our example, let’s assume that the business pays back a $150,000 debt balance during Years 1 to 3 at $50,000 each year.

Here is the final version of our valuation calculation.

Table 6. Final Version of the Business Valuation Model

Year 1

Year 2

Year 3

Year 4

Year 5


Profit

$100,000

$100,000

$100,000

$100,000

$100,000


Depreciation

$20,000

$20,000

$20,000

$20,000

$20,000


Changes in Working Capital

$0

-$50,000

$0

$0

$0


Loans paid back

$0

-$50,000

-$50,000

-$50,000

$0

New loans taken

$0

$0

$0

$0

$0


Free Cash Flow to Equity (FCFE)

$120,000

$20,000

$70,000

$70,000

$120,000


Present Value of FCFE

$104,348

$15,123

$46,026

$40,023

$59,661

+

Total Present Value of FCFE

$265,181






Terminal Value





$402,259

+

Present Value of Terminal Value

$199,994


Business Value

$465,175





There you have it!

An accurate, scientifically-based, yet very practical business valuation. Taking forecast profits, adjusted appropriately to find Free Cash Flow to Equity. So you can arrive at an Asking Price that you can justify.

It doesn't involve complicated math. If you are still not sure about how the numbers were generated, go back with your calculator and re-check the example.

Video: How to value a company using Discounted Cash Flow (DCF-method) - by MoneyWeek Investment Tutorials

Plan, prepare and advertise your business for sale with ExitAdviser

As Discounted Cash Flow uses the major drivers of business value it's an equally useful tool for a buyer to check that your Asking Price is fair. The model is robust, so any discussions during negotiation are likely to be about the input assumptions made.

Download the Valuation Model (xlsx)

Get more education

What is Business Valuation (by Wikipedia)

Business Valuation using Discounted Cash Flow Method by Wikipedia

Business Valuation Formulas and Models

Top 4 Business Valuation Methods (with videos and examples)


small logo Published by ExitAdviser | | all rights reserved