How to Value a Business: Multiple Methods
- Discounted Cash Flow: Shows the present value of a business’s future cash flow, discounted according to the risk involved in purchasing the business.
- Capitalization of Earnings: Shows a business’s future profitability, accounting for cash flow, annual ROI, and expected value. This method extends calculations for a single period into the future.
- Asset-Based Valuations: Calculates the net value of a business’s assets, both tangible and intangible, minus the value of its liabilities.
- Market-Based Valuation: Calculates company’s value based on the purchases and sales of comparable companies within the same industry.
Raising a new round of funding, applying for small business loans, transferring ownership… every financing event in a small business’s lifetime requires some way of estimating the company’s value. Wherever you are in your business’s lifecycle, you’ll want to know how to value a small business sooner rather than later. Feeling confident in your appraisal will help you accurately determine how to pitch investors and raise funding, or price your business to find the right buyer.
A valuation represents your company’s total worth. You’ll calculate your business’s value with a specified formula, taking into account your assets, earnings, industry, and any debt or losses. Entrepreneurs looking to buy an existing business should also be familiar with valuations, and feel comfortable estimating value independently of the business owner or broker’s asking price.
If buying and selling businesses is a new frontier for you, you can consult any number of online resources to help you determine the value of a business. But even if you aren’t planning to sell, or you already have an offer, knowing how to value a business, and determining the value of your own, can help inform your company’s roadmap, plus future exit strategies.
In This Article
Keys to Determine the Value of a Small Business
Conducting a valuation is an excellent opportunity to assess the financial health and potential of your business, or of a business you’re hoping to buy. Along with doing financial legwork, valuing your business also requires you to exercise control over any emotions. Particularly if this is your first company, or if you run a family-owned and operated business, take care to approach valuation as objectively as possible to come to an accurate number.
1. Understand Your Valuation
Unless you’re a natural-born business or numbers person (or, say, an accountant), business valuation isn’t the easiest process. You’ll need to understand some key definitions first:
Seller’s Discretionary Earnings (SDE)
If you’re familiar with EBITDA, you’re probably already familiar with SDE (seller’s discretionary earnings), too, even if you’ve never heard the term. As a reminder, EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization—essentially, it’s the pure net profit of a business.
Like EBITDA, business owners calculate SDE to determine the true value of their business for a new owner, so your SDE will include expenses like the income you report to the IRS, non-cash expenses—whatever revenue your business actually generates. Unlike EBITDA, though, you’ll also add back in the owner’s salary and owner’s benefits into your SDE calculation. Large businesses generally use EBITDA calculations to value their businesses, and small businesses typically use SDE, since small business owners often expense personal benefits.
It’s crucial that prospective buyers understand SDE, too. Most likely, business owners will provide you with that number, so it’s important to understand how the business owner reached that value, and what these values reflect about the actual business.
To calculate your business’s SDE: Start with your pre-tax, pre-interest earnings. Then, you’ll add back in any purchases that aren’t essential to operations, like vehicles or travel, that you report as business expenses. Employee outings, charitable donations, one-time purchases, and your own salary can all be included in your SDE. (Buyers might ask about your discretionary cash flow when you offer them your valuation, so be prepared to include and value each major expense or purchase.)
Finally, any current debts or future payments, called liabilities, are subtracted from the net income. More on liabilities in a bit.
Your SDE represents the true, monetary value of your business, but your SDE multiple values your business according to industry standards. (If you used EBITDA to value your business, you’ll use an EBITDA multiple.) As we mentioned, though, more often small businesses should use SDE for their business valuations, since small business owners usually pull a large percentage of their business’s revenue for their salary and living expenses.
There’s a different SDE multiple for every industry. Your particular business’s SDE multiple will vary based on market volatility, where your business is located, your company’s size, assets, and how much risk is involved in transferring ownership. The higher your SDE multiple, as you might expect, the more your business is worth.
2. Organize Your Finances
Because the process for determining the value of a small business is complicated, you might want to consider consulting a professional business broker or accountant that specializes in valuation, rather than going it alone. That said, you’re fully capable of valuing your business using your own resources. First, though, you have to get your financial information in order.
Before even thinking about how to value a small business for sale, both sellers and buyers should organize their financial records—that’s crucial for accurate calculations. And beyond conducting your valuation, you’ll need your finances in order to transfer business ownership, regardless.
Sellers will need to have the following documentation in order to ensure a smooth valuation process:
- Licenses, deeds, and any proprietary documents
- Profit & Loss statements for the last three years
- Tax filings and returns
- Short overview of your business or personal finances
A quick note on those tax returns: Remember that many purchases you reported as business expenses to the IRS—like the cost of travel expenses, a personal vehicle, and many other non-essential, non-recurring purchases—should be added back to your earnings when calculating your SDE.
Buyers obviously won’t need all of these documents, but they should still review their own financials. It’s likely that any sellers you’re working with will want to see your credit report and basic financial profile.
Establishing a firm financial foundation will help you maintain realistic expectations about the value of your company (or the company you’re hoping to buy). The more thorough you are in this step of the valuation process, the more confident you’ll be in your calculations.
3. Take Stock of Your Assets
You might think that you can’t actually distill the value of your entire business to an exact number—and, sure, in a way it’s a bit of an estimate. But as a seller, you have to put some number on your operation, especially if you want to be compensated for what you’ve built, taking into account all kinds of equity.
Your best angle is to make a list of the production, property, and resources that comprise your business—assets and liabilities, cash and investments, employees, and intellectual property. Later, too, you can use this list to create an overview of your company’s value for potential buyers. This is another opportunity to seek the counsel of a mentor or a professional advisor, who can provide insight into your business’s assets from a more objective perspective.
Sellers will need to follow steps to properly take inventory of your assets:
Make a detailed report of your business assets and liabilities.
Here, business assets include anything that adds value to your company. This means intellectual property, your production line, your delivery truck—if it’s a part of your business, you’ll either need to account for it as an asset or a liability. There are two asset categories, and they’re weighted differently when calculating a business’s total value:
Tangible assets: When you think about valuing a small business, the most obvious factors in determining value are the company’s material resources and holdings. Examples include:
- Real estate or property
- Equipment or means of production
- Inventory or stock
- Cash on hand
Intangible assets: These are all the non-material assets that add value to your business. Intangible assets are crucial to your SDE multiple, so it’s important to identify and record their estimated value. These could include:
- Patents, copyrights, and trademarks
- Other intellectual property
- Brand and reputation
- Customer loyalty or subscriber base
You’ll also need to know your liabilities. Liabilities include any debt or outstanding credit on your business’s books, and they detract from the overall value of a business. (That’s why this number is subtracted from the SDE in valuation calculations.) Often, sellers keep their business liabilities and pay off their debt after their business is sold.
Liabilities that will factor into your calculations include:
- Notes payable
- Accounts payable
- Business loans
- Accrued expenses
- Other debts or payables, as well as unearned revenue
Outline your business plan and model.
If you’re selling, your prospective buyer will need to understand how you generate revenue—and will continue to.
Business plan: A strong business plan helps you make accurate projections for earnings and market growth. Plus, it’s crucial to demonstrate to potential buyers how your business will continue to grow and turn a profit. Overall, a strong business plan provides buyers with important context about your company—like your location and mission—and captures what key services or goods you offer.
Business model: Your business model demonstrates how you make money, be it a subscription-based service, direct-to-consumer ecommerce, or B2B consulting. A valuation is a suggestion of value, but your business model shows potential buyers how they’ll actually reach their customer base to generate revenue if they purchase your company.
But buyers aren’t exempt from this step in the process! If you’re considering acquiring a business, composing a list of your target’s assets and liabilities will ground your decision in sound financial judgement—and make sure you and the seller are on the same page with valuation. You should also look for business plans that clearly outline processes and, ideally, demonstrate consistent management. A well-run business will make transitioning ownership, without losing profits in the process, significantly easier.
4. Research Your Industry
Familiarity with your industry is crucial for both buyers and sellers. Before buyers can confidently make an offer on a business, they’ll need to become well-versed (if not an expert) on that business’s industry. On the sell side, a deep understanding of your industry’s trends can help you reach an informed valuation that reflects your business assets as well as the current market.
As we mentioned earlier, a business’s SDE multiple—and the method of valuation—varies according to a few factors, including the strength of the industry. So, sellers should find out as much as they can about companies that are similar in size, business model, and revenue, if that information is available.
These similar businesses, often referred to as “comparables” or “comps,” can orient you within the marketplace and provide context about the sector. Knowing your peer companies will also help you assess your market share and growth potential. Then, you can demonstrate to potential buyers what makes your business stand out.
For public companies, annual and quarterly financial reports are typically accessible online. Depending on the degree of corporate transparency, you can also see what comparable businesses are selling for. Internet companies or buyers interested in the tech sector can use online directories like Crunchbase and platforms like AngelList, which provide information about startups, funding, investors, and more.
How to Determine the Value of a Small Business
With this toolkit, you should be ready to determine your business’s value (or to determine the value of a business you have your eye on.) But you’ll need to choose the right valuation method. Whatever method you choose, know that the key to a solid business valuation is accurate accounting and reasonable estimates. An inflated valuation will skew your understanding of your business—not to mention turn off potential buyers. On the other hand, undervaluing your business could potentially hurt your profits.
So, the best way to accurately value your business is to make fact-based earnings projections. That means focusing in on accurately valuing your business’s assets and liabilities, and doing so objectively.
Approaches to a Successful Business Valuation
|BUSINESS VALUATION METHOD||WHAT DOES THIS VALUATION METHOD CALCULATE?||WHO SHOULD USE THIS VALUATION METHOD?|
Discounted Cash Flow
The present value of a business’s future cash flow, discounted according to the risk involved in purchasing the business.
Newer businesses with high-growth potential, but which aren’t yet profitable.
Capitalization of Earnings
A business’s future profitability, accounting for cash flow, annual ROI, and expected value. This method assumes that calculations for a single period of time will continue in the future.
Established businesses with stable revenue.
The net value of a business’s assets, both tangible and intangible, minus the value of its liabilities.
Businesses that hold investments or real estate; that aren’t generating a profit; or are seeking to liquidate.
A company’s value based on the purchases and sales of comparable companies within the same industry.
Any business, as long as you can find sufficient data on comparable companies.
There are really four business valuation methods (nested within three approaches) that you need to be aware of. Each uses a different aspect or variable of a business to calculate its numerical value—either a business’s income, assets, or using market data on similar companies.
Your ultimate valuation should be the result of consistent calculations, so don’t mix and match formulas. That said, doing the math is free, so go ahead and plug your earnings numbers into different formulas, and compare. Investigate numbers that don’t seem right, and don’t be afraid to call in an accountant for extra help.
1. Income Approach
The income approach to business valuation determines the amount of income a business can expect to generate in the future. If you want to take the income approach, you can choose between two commonly used valuation methods.
Discounted cash flow method: This method determines the present value of a business’s future cash flow. The business’s cash-flow forecast is adjusted (or discounted) according to the risk involved in purchasing the business. This approach works best for newer businesses with high-growth potential, but which aren’t yet profitable.
Capitalization of earnings method: The capitalization of earnings method also calculates a business’s future profitability, taking into account the business’s cash flow, annual rate of return (or ROI), and its expected value. But where the discounted cash flow method accounts for more fluctuations in a business’s financial future, the capitalization method assumes that calculations for a single period of time will continue in the future. So, established businesses with stable profitability often use this valuation approach.
Most online business valuation calculators use a variation of the income approach. But if you have more financial information on hand, you can try a more comprehensive business valuation tool that includes both profit and revenue, as well as assets and liability, in the calculation.
2. Asset-Driven Approach
Another common method attributes value to a businesses based solely on its assets. In particular, the Adjusted Net Asset Method calculates the difference between a business’s assets—including equipment, property, and inventory, and intangible assets—and its liabilities, both of which are adjusted to their fair market values. Asset valuations are also a great tool for internal use, and can help you keep track of spending and capital resources.
To do an asset-driven assessment, you’ll make a list of your assets and assign them a monetary value. For equipment or other depreciating assets, that value is usually somewhere between the sale price and the depreciated value. A good rule of thumb is to estimate how much a piece of a equipment would sell for today, and use that number.
Because you’re familiar with your own equipment and production, you can make pretty accurate estimates of each of your asset’s value and depreciation. Even if you don’t adjust the asset’s worth according to the current market, you can still get a good sense of a business’s material value. This method is especially useful if your business mostly holds investments or real estate; isn’t profitable; or if you’re seeking to liquidate. In any of those cases, buyers will be interested in the individual value of your investments or equipment.
3. Market Approach
As you can deduce from its name, the market approach to valuing a business determines a company’s value based on the purchases and sales of comparable companies within the same industry. This approach will specifically help you determine an appropriate selling or purchase price based on your local market. Any business can use this approach to business valuation, as long as they can gather sufficient, relevant data on which to compare their business. It can be an especially useful approach for rapidly growing businesses and industries.
What to Do If You Plan to Sell Your Business
If you’re serious about looking for a buyer, be mindful of the impact that selling your business will have on your employees. In the exploratory stages, it’s a good idea to keep things confidential. Even if you’re committed to ensuring that your employees are taken care of, news that you plan to sell your company will likely impact the work environment.
So, even before you begin valuing your business, decide how much information to share with your employees. Depending on your team and your management approach, you might choose to include everyone in the process—and if you don’t personally handle your business’s finances and tax filings, there’s a good chance your employees will be involved, anyway.
In that case, you might want to consider a non-disclosure agreement. Keep in mind, too, that both your business’s partnerships and your customers will be affected when your business is sold.
Although a sale may be far in the future, these relationships will start to change as soon as you announce plans to sell your company.
The Bottom Line
Whether or not you’re valuing your business to prepare for a sale, having an accurate number in hand can only be positive. Once you’re confident in your valuation, you can mobilize your knowledge about your assets and earnings to make decisive improvements or necessary changes.
No matter where you are in your business’s lifecycle, learning how determine a business’s value is a great way to better understand your own business’s finances and assets within the context of your industry. Plus, knowing the value of your business can help you navigate any unexpected market turns or inbound offers.
And if or when the time comes to sell, you can start thinking about how to maximize your profit as you transfer ownership.
- FirstRepublic.com. “How to Value Your Company: The Asset-Based Approach“