Business Valuation Methods



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Your business is your major asset and it is understandable that you want to know its value. Think the business valuation as a "subjective science". The science part is when valuing your business - you have to apply standard valuation methods. The subjective part is that every buyer’s circumstances and considerations are different, so for the same business two buyers may propose two different offers.

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In general, no fixed rules or formulas apply to value how much your business is worth. Its value will always be what you are willing to sell for and what the potential buyer is willing to pay. Nevertheless, there are a few frequently used valuation methods that can help you to start the negotiation process.

The basic ideas are simple, but you need to understand the details to know the calculations.

Related: Online Business Value Calculator

Let's go into details.

1. Profit multiplier

In profit multiplier, the value of the business is calculated by multiplying its profit. For example, if your company’s adjusted net profit is $100,000 per year, and you use a multiple like 4, then the value of the business will be calculated as: 4 x $100,000 = $400,000

From the potential buyer’s viewpoint, this means that as long as the business continues to make profits at the same level, they will get roughly $100,000 per year for the $400,000 investment, i.e. a 25% return.

After four years they will get the full return on the investment. Compared to the bank or other investments this is a highly profitable return. The profit multiplier method is also known as the Price to Earnings or P/E Ratio, the price being the value of the company and the earnings being the profit that the company generates.

Determine the multiple

If pre-tax profit is used, commonly applied profit multiples for small businesses would be between 3 to 4 and occasionally 5. The P/E multiples may be applied higher for larger publicly traded companies, normally anything from 7 to 12 and in some cases, when they have high growth potential, even more. This is one of the main reasons why large corporations can acquire smaller business and instantly revalue them at a higher price.

Obviously, the multiple that you will use have a huge effect on the valuation of the company. A larger business with a track record of good profits and with several potential buyer is likely to value by a higher profit multiple.

There are also a few more aspects for you to know.

Adjusted profit

Adjusted profit essentially means as an owner, you can’t pay yourself a small salary to raise the value of the business. For example, a company is generating $30,000 profit, but after some investigation, it appears that the owners aren’t taking any salary. When the market-based salaries are taken into account, the profit is reduced to nothing. Even the established business owners generally take salaries below market rate to improve cash flow or for tax reasons. Buyers understand this process and expect the owner’s salary to be taken into account. This is the reason adjusted profit is used.

There may be other transactions that are exceptions, for example, you may work from home or own the business premises. You will benefit from lower rent or no rent at all, which wouldn’t apply for the new buyer. Basically the potential buyer wants to rest assure that the profit is accurate and the company will generate the same amount after you are no longer the owner of the business.

That concept is also known as Seller's Discretionary Earnings (SDE). It is measured by EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and adding owner’s salary, compensations and perks.

Average or normalized profit

If, say, last year was a good year for your company in terms of profit generation, you obviously want to highlight that period to the buyers, but professional buyers want the average profit calculation of the last few years.

EBIT and EBITDA

For some companies it is wise to make further corrections in a profit multiplier calculation, such as EBIT or Earnings Before Interest and Tax.

This is the adjusted profit that your company makes without the effect of tax and interest. The EBIT calculation is frequently used when a business is valued or sold based on any debts and surplus cash removed from the balance. The EBIT gives a demonstration of the earnings of the business without the destabilizing effect of debts or surplus cash balance.

You may be thinking why are valuations calculated without any tax?

The reason is that once the company is merged into a larger group or corporation, the tax position of the group as a whole may be different. The valuation is agreed based on the profit after tax and as long as both seller and buyer understand and settled for this, there shouldn’t be any problem. But remember one thing, if they are based on pre-tax profit, the multiples used to calculate the value will be less.

EBITDA or Earnings Before Interest, Tax reduction, Depreciation and Amortization are similar to EBIT. In addition, it explains that profit or adjusted profit is without the effect of any corrections due to the devaluation of assets or repayment of any business loans.

Let’s take a hypothetical example.

Imagine you own a successful business that is making a profit of $60,000 for few years. Your business then has an excellent year and takes the profit up to $100,000 and left you with a $50,000 retained profit. A potential buyer gets interested and says he will buy the company based on a 5 time multiple valuation. It seems like an excellent offer, but you have to consider and clarify a few things before you can accept the offer. If the 5 times multiple is based on any or all of the following factors, it will be far less attractive.

  • If the profit is adjusted based on your increased salary, it will reduce the profit by $20,000 each year.
  • If it was based on an average profit of the last 3 years, which is $53,000 instead of $100,000.
  • Instead of taking the profit with you, you may have to leave the $50,000 in the business as a part of the working capital figure.

Based on the above figure, rather than receiving $550,000 after sale, you will walk away with only $265,000. The 5 time multiplier valuation doesn’t look attractive now.

Video: How to value a company using multiples – by MoneyWeek Investment Tutorials

2. Comparables

A common valuation method is to look at a comparable company that was sold recently or other similar businesses with known purchasing value. For example, office and home security companies typically trade at double the monitoring revenue, and accounting firms trade at one times gross recurring fees. You can ask around at your annual industry conference and find out what is the selling price of similar companies in your industry.

The main problem with the comparables method is that it often leads to an apples-to-bananas comparison. For example, if you try to compare your company with similar fortune 500 counterparts, you will be disappointed.

3. Discounted cash flow method

The discounted cash flow method is similar to the profit multiplier method. This method is based on projections of few year future cash flows in and out of your business. The main difference between discounted cash flow method from the profit multiplier method is that it takes inflation into consideration to calculate the present value.

Present value

Present Value (PV) is today’s value of the money you will collect in the future. Let’s look at another example to understand how it works.

Let's think that I’m offering you $1000 now, or $100 a year for 12 years (starting next year). Which would be a better offer for you?

You may think that $100 for 12 years is a much better offer (12 x $100 = $1200), i.e. $200 more. However, you have to take inflation rate into consideration. To make the calculation simple, let’s assume an inflation rate of 5%, so the $100 that you are going to get next year is equal to circa $95 this year.

Take a look at the table below, the $100 you will get the following year will be worth even less and after 12 years the present value of $100 will only about $56.

Table 1. Present value of $1000 today versus $100 for twelve years

Year

$1000 up-front PV

$100 per year PV

0

1000

0

1

0

$95

2

0

$91

3

0

$86

4

0

$82

5

0

$78

6

0

$75

7

0

$71

8

0

$68

9

0

$64

10

0

$61

11

0

$58

12

0

$56


Total

$886

As you can see the installment offer seem much better offer at first, but after inflation calculation, it adds up to only $886. Some may think it’s still an attractive offer, but there is something else to consider

How-to video: Business Valuation St. Louis presents a summary about valuation methods such as Income Approach and Discounted Cash Flow (DCF) Model.

Opportunity cost

If you have received $1000 today then you could have invested the money in something profitable and get a good return every year. With $1000 upfront you can invest and get a return, but with only $100 you don’t have that opportunity, this is called the opportunity cost.

If you had invested $1000 in something profitable and receive a flat return of 10%, within 12 years your money would have grown to $2881, the amount would have a net present value of $1605. You have to take all of these factors into account with a discounted cash flow valuation.

How it is calculated

You need to estimate the cash revenues coming into the business and expenditures going out of the business for a number of years into the future to calculate a discounted cash flow valuation. Taking the expenses out of the profit will give you each year’s net cash flow. Apply an accurate discount rate (also understood as the cost of equity) to each year’s figure to get the net present value of the future profit. This gives the discounted cash flow.

The potential buyer can compare your business against other investment choices that they may have, each with their own different levels of risk and return. Just like the profit multiplier method, this method also comprises a lot of details. Considering inflation and risk, what level of discount rate to apply for each year, how many years to calculate, and should you consider the net present value of the business at the end of the period (known as "terminal value").

To learn more, check out the How-to Guide on business valuation based on discounted cash flows.

4. Asset valuation

With this method, it’s not the profit generating capabilities of your business; rather than the net value of the assets in your business. If everything in the business was sold and all debts were paid, this value would be achieved.

The net asset value of your company is the total market value of all the assets it holds, such as equipment, machinery, computers, cars and properties; subtracting the value of any liabilities, such as debts, leases, finance or other money or equipment owed. Basically, if you sold all your assets and paid all your debts, you will be left with net asset value (or "book value").

Applying asset valuation is generally more realistic if your company has a large amount of assets and/or its long term revenue generating capabilities are limited.

Market value

You can calculate the book value of an asset by deducting any depreciation from its original price. The assets that the business owns, your company’s accounts will show the book value of those assets. However, the market value of those assets might be different.

Your business has to arrive at the market value of its assets to reach the net asset valuation. This will require you to hire a CPA or qualified Appraiser to assess the value of the properties.

Other valuation aspects

Hopefully you now realized from the profit multiplier valuation method, the simple general rules contain a lot of numbers and details that have to be negotiated further. Following are a few more that you should understand

Surplus cash and long term debt

Businesses are generally valued without considering any surplus cash or long term debts. Valuation works on the basis as if there is no surplus or debt, the actual selling price is then adjusted to take them into account.

For example, imagine that a business valued at $500,000 has debts of $100,000. The buyer may offer to pay $400,000 for the business and accept the $100,000 debt. This is basically the same result if the seller pays the $100,000 debt and sells the business for $500,000.

You may have seen in the news that a business being bought for only $1 and wondered how and why?

This happens when a company has huge debt and can’t afford to repay. If any buyer purchases the company, they have to pay the debt. So if the company has $1 million of debt and sold for $1 that means the business is costing the buyer $1,000,001

For any contract to recognize as valid, there needs to be some give-and-take of value. It’s called the consideration.

Surplus cash and working capital

Any company needs a certain amount of working capital to function for a reasonable period into the future, any excess amount is considered as surplus cash. The amount differs from business to business and the exact figures have to be discussed and agreed between you and the buyer.

If your business has a large cash surplus, then you may go through with the sale process and follow a tax efficient way to take out the cash, but be careful there are drawbacks.

Firstly, as a part of the business sale, the buyer may be ready to buy this cash from you. To compensate for their trouble, they will pay you less than its actual value, for example, for every $1, they may pay 90c.

Secondly, if you want to take advantage of the tax benefits, you have to comply with a certain restriction on how much money you can take out of the company.

This is a complex area and you need guidance from your Tax Adviser or Accountant.

Goodwill

When it comes to the valuation of your business, goodwill points out to the adjustment between the calculated value of your business and its net assets. So if the market value of your business is $1 million but actually holds only $600,000 worth of assets, the rest $400,000 of value belongs to goodwill.

It can be negative.

If the value of your company is less than the value of its assets, then the difference between the two is a minus number and become negative goodwill. If your business has a lot of assets, such as property or land, the negative goodwill can occur. So use an asset based approach when valuing your business.

The buyer decides which method of valuation he wants to apply to your business. If they decide your business is strategic, you will get a handsome profit for your company, otherwise you may get less then you have hoped.

I’m confident that these valuation methods will be really useful for you when you start the valuation of your business. There is a saying in the capital industry "the real value of a company is only what a buyer is willing to pay for it". In other words, the condition of the business, the market, how skillfully you attract the investors and negotiate with them all determines the value of your business.

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