Determining the Value of a Business: What You Should Know
Most businesses looking to sell or merge must determine their fair market value. It is also vital to negotiations if you are considering accepting financial input from an investor. This helps you determine the appropriate funding to accept and stakes to allocate.
If you run a small business, you might not be interested in calculating terminal value, future cash flows, cost of capital, and other complex valuations.
Thankfully there are several ways to quickly determine your company's value and skip the complicated finance theories.
Different Methods for Determining the Value of a Business
Here are the different methods you can use to determine the value of a business.
Asset Method
This method involves subtracting your total liabilities and debts from the value of your business's assets. For instance, if your business has $50,000 in assets and $10,000 in liabilities and debts, its total value is $40,000.
The asset method gives you the current value of your business and does not factor in future earnings or revenue. It is not recommended for profitable going concerns.
Income Method
This method is based on the revenue a business generates annually. Financial experts commonly use it; however, it can be complex for small business owners.
The income method involves forecasting a business’s financials or future income and adjusting for taxes, growth rates, working capital, and depreciation.
The future valuation is then discounted to arrive at its present value, which involves discounting the cash flows.
Markets Method
The market method is quick and may be better suited to give a more accurate representation of your business’s value.
Consider what similar businesses have successfully sold and multiply your seller’s discretionary earnings by that number. Valuation is a multiple of SDE, usually from 1 to 4 times.
To get a valuation, reduce gross profit to ensure earnings are determined only on operating expenses such as:
- Income tax
- Non-recurring expenses
- Interest income or expense
- Amortization and depreciation
- Non-operating expenses and income
This method is commonly used for small businesses such as sole proprietorships. Common multipliers, in this case, may include location, risk, age of the business, or competition.
Discounted Cash Flow Analysis Method
The DCF method focuses solely on your business’s projected cash flow.
While it is a more complex formula, it accounts for future income and shows how much an investor might have made in profit if they kept their money.
If your business’s present value is more than the investment, it is considered a good investment.
Factors Affecting the Accuracy of a Business Valuation
While the above methods can help you determine the value of your business, buyers and sellers must still negotiate and agree on a figure.
However, most business valuations are exaggerated, and sellers do not consider factors that may affect accuracy.
Some of these factors include:
Economic Conditions
The economy affects all businesses. Factors such as potential market growth are affected by the economy but are used to determine the potential value of a business.
Consider economic factors in valuation to present a more accurate picture to prospective buyers and investors.
Location and Market
If you run a real estate business, your valuation is significantly affected by location and market. Location factors may also affect other businesses if the sale involves moving the business to another city, country, or state.
Capital Assets
Some business owners make the mistake of tying asset value to their business value. Your business worth is affected by capital assets.
However, investors are interested in something other than how much money they can make from selling your assets.
Business valuation is about how much profit a buyer can earn through products and services, not how much money is tied up in the business in capital assets.
Technological Factors
It can take time to determine the value of any technology, such as websites and online sales. However, these have a significant impact on the value of a business.
They can also positively or negatively impact the business's reputation, affecting its valuation.
Elements Involved in Determining Your Business’s Value
The critical elements determine the value of your business.
- Net income: This is your gross profit less all expenses.
- Multiples: Generally, riskier businesses have lower multiples. Multiples are determined by the industry, your business’s financial history, stability, future income, and customer base. Sole proprietorships might have higher multiples, but only large companies can expect double digits.
- Market: The market affects valuation because it significantly determines future profitability. A stable, well-established business can use historical figures, while a new business offers the potential for considerable growth.
- Potential Growth: You need a financial accounting expert to determine potential growth. However, it offers a more accurate representation of what investors and buyers can expect as predicted by industry experts.
- Growth Projections: If using historical data to determine your business valuation, remember to add projected growth incrementally to annual profits.
Summary
There are many methods to determine the value of your business. Ultimately, its true value is determined when the seller and potential buyer agree.
However, understanding the different valuation methods is still useful to ensure you go into negotiations with an idea of a fair value.
Whether you run a big or small business, it is always best to consult a professional accountant to help determine which valuation method is best for your business.
A more accurate representation of the true value of your business can help you and potential buyers or investors negotiate more effectively.
