The valuation process can be complex, especially for small business owners, as it uses multiple methods and can vary depending on the assets being valued and overall perceptions of value. Each process also has its limitations. Here we dive into the basics of valuation, the methods and factors that are used, and what you need to be aware of to accurately determine your business’s value.
Why Your Business Valuation Matters
The valuation of a business is important, as it gives insight to how much your business is worth, which is useful in various business dealings. Typically, investors and business owners are more interested in this number since it is used when making major financial decisions, such as selling and buying stocks, selling or purchasing a company, and company mergers. Valuation is also important if you are looking to expand your business, especially since you’ll need more capital to grow. To raise this capital, you’ll be asked to prove your business’s worth to potential investors.
Factors That Impact Business Valuation
There are several factors that are considered when completing a business valuation.
Financial Statements and Documents
To begin the valuation process, you will need to gather several documents and statements. A business appraiser will use the data from statements, such as your business’s income statement, balance sheet, cash flow statement, and tax returns. These documents must be reported accurately to get a clear look at your company’s valuation.
Reason for Valuation
Depending on the reason for the valuation, it may need to be certified. If the purpose of the valuation is simply for your internal purposes, this isn’t required. However, if the valuation is needed for potentially selling your business or for tax or legal purposes, then it will most likely require a lengthy report certified by a professional appraiser.
Book Value vs. Market Value
When analyzing the value of your business’s assets, it’s important to understand that they may be valued at either book value or market value. Book value represents the actual amount that was spent on the asset, so it is equal to its price at the time it was purchased minus its depreciation. Though book value seeks to be accurate, it may make use of different methods for depreciating and doesn’t account for the current price in the market. Market value considers the current value of an item. It determines the value of the asset as if it were available in the market today.
Methods To Determine Valuation
Businesses can use different methods to figure out their valuation, including book value and market value. Some methods are based on the forecasted growth of the company, others consider the current market. Typically, more than one method is used to improve accuracy, and certified business valuations may use several types of methods. Some common methods include:
Discounted cash flow valuationRelative valuation (market approach) Income approach
A discounted cash flow valuation estimates your business’s worth by calculating its future growth based on its expected cash flow. This method takes into account the current value assets based on how well you generate cash flow. A relative valuation may be referred to as the market approach. It values assets based on the other values given to other similar assets, or comparable assets, in a market. This method considers the current market and essentially determines an asset’s worth based on competitor analysis. The income approach looks at your business’s income statement to evaluate its revenue and expenses. This method focuses on the value of profits and doesn’t account for intangible assets.
Limitations of Business Appraisals
A valuation will offer significant insight into your company’s value, however, there are some limitations. It may not always be an accurate representation of your business’s worth and may be interpreted differently by investors and potential buyers. A valuation essentially represents an estimate of how well your business is expected to perform, which can quickly change over time due to many factors. The current market and economy can play a role, as well as changes in the expected cash flow. One important consideration is the potential inaccuracy of data provided from your company’s financial statements. If your business does not account for all assets and liabilities or leaves out pertinent data by mistake, the valuation will then be inaccurate. If certain parts of the statements are interpreted differently, such as depreciation or using book value versus market value, this can also affect the outcome. Though some businesses may use both methods to improve accuracy, using only one may not equal the amount of a business’s assets when liquidated. Another limitation is whether goodwill is considered in the company’s worth. Goodwill refers to the additional amount an investor is willing to pay on top of its fair market value to acquire a company. It is the added value that isn’t represented in financial statements, as it includes intangible assets. Intangible assets are assets that are not physical items, such as trademarks, copyrights, client base, reputation, network connection, and other assets that are valuable, but are not actually valued with a dollar amount. The value of intangible assets may be interpreted differently and can even fluctuate depending on many factors, such as branding competition and market trends.
The Bottom Line
While business valuations can be helpful when completing major business transactions, such as acquisitions and mergers, they also have their limitations, as they are generally considered estimates of the business’s potential growth. When conducting a valuation, it is important to ensure your company’s assets are properly valued and to consider different methods to create a more accurate representation of your business’s worth. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
title: “How To Determine The Value Of A Business” ShowToc: true date: “2022-12-12” author: “Rosalie Porter”
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.
Asset Valuation
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
ReputationName recognitionCustomer loyaltyTrademarks and trade nameSkilled employeesSpecialized 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.
Cash Flow
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.
Gross Sales
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 taxesNonrecurring income and expensesNon-operating income and expensesDepreciation and amortizationInterest 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.
Economic Conditions
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.
Technological Factors
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.
