As a business grows and develops, there may come a time to consider selling it. You might even be approached with an offer. And while plenty of owners decide they are happy to continue forward at full steam, there are good reasons to think through all the options.
To do this, business leaders need to understand what goes into determining the value of your business. There are a number of approaches you could take, and some are better suited for certain types of businesses than they are for others. Knowing which type is best for you and how to go through the process can help you maximize the returns on your sale.
The Limits of Business Valuation
Before diving into the various approaches to determining business valuation, it is important to understand the limits of the process. Business valuation is just as much an art as it is a science, and ultimately, the amount a business is worth is the amount that a buyer is willing to pay for it.
Several factors can have an influence that goes beyond the business itself. The market can be in the midst of a downturn, newer technologies can erode the value of existing ones, or a planned highway expansion that would have made shipping easier for a business could fall through. The infrastructure around your business — both social and physical — can have ripple effects that make their way into the business valuation.
It is also worth noting that many approaches to business valuation rely on projecting values into the future, and that is an inherently tricky prospect. There are also plenty of things that have a value that is difficult to quantify, like brand equity or goodwill. These kinds of dynamics lead to a reality where it is exceedingly difficult to understand the true value of a business.
If possible, it is, therefore, a good idea to consider using multiple approaches to business valuation. By generating a handful of values derived through multiple methods, you can approach the process with greater confidence.
Different Types of Business Valuation
Whether it’s a small business or a multinational conglomerate, there are several different business valuation methods to consider.
- Asset Valuation
- Cash Flows
- Multiples of Earnings
- Market Value
- Seller’s Discretionary Earnings (SDEs)
How to Determine the Valuation of a Business
It can be difficult to understand how to determine the value of a business. Depending on the method you choose, the variables and equations can seem to defy the hope of a simple and straightforward process. But in many cases, it is not as complicated as expected.
Here are some outlines of common business valuation methods and how to navigate the process.
Asset-based valuation is all about knowing the value of everything your business owns — if it appears on the balance sheet, it can be tallied to produce a total value. This includes tangible assets like buildings, equipment, supplies, cash, accounts billable, and more. Intangible assets can be harder to quantify but still have value. These can include brand recognition, client relationships, intellectual property, and other dynamics.
This is essentially getting a sense of what it would cost to build a new business with all of the same assets by purchasing them at their fair market value. But there are some different approaches within that mission.
- As Liquidation: Common in bankruptcy, valuing assets as liquidation tallies the raw material value of each asset. This value is typically less than that of an asset being appraised as part of an operating business.
- As a Going Concern: Assets as a going concern (also known as “book value”) are valued within the context of a fully functioning enterprise based on how they appear on the balance sheet. The value is typically greater because they are being treated as essential components of a larger whole whose overall value exists only by virtue of their presence.
Cash Flow Valuation
Valuing a business based on cash flows takes into consideration how much income the business is bringing in — and what it expects to bring in over time. This is a common valuation method for businesses that have shareholders.
- Discounted Cash Flow Method: Discounted cash flow (DCF) estimates future earnings and then discounts those earnings to their present value. It is among the most reliable valuation methods because it is able to account for so many different variables.
- Capitalization Past Earnings: Past earnings are used to estimate future growth. Then, after accounting for regular expenses, cash flows are multiplied by either a capitalization factor or by the rate of return after factoring for risk.
Multiples of Earnings
Common among companies with stocks, the multiples of earnings approach calculates the value of a business based on its ability to produce wealth for its shareholders. The greater the earnings per shareholder (EPS), the greater the valuation of the company.
Valuation is determined by calculating the total EPS, factoring in interest, taxes, depreciation, and amortization (EBIT or EBITDA). This number is then multiplied by the total number of shares.
Market valuation is a relatively straightforward way to estimate the value of your business. Simply put, it compares your business to businesses that have recently sold and uses those purchase prices as the baseline.
A market-based valuation approach is good when there is a lot of competition, but less so when there is not. That is because it depends on the sale price of similar companies. If there are only six or seven companies like yours and only one of them has sold, you may not have the best sense of how the market will value your business. Conversely, if there are 100 businesses like yours and 20 of them have sold, you have much more reliable figures to put to work.
- Market Capitalization: A common (but indirect) point of reference for understanding the value of publicly traded businesses, market capitalization (or market cap) multiplies the share price by the total number of outstanding shares.
Seller’s Discretionary Earnings (SDEs)
This method is similar to multiples of earnings, but it is most appropriate for a small business that has a single owner like a sole proprietorship or professional practice. The goal is to determine earnings based on operating expenses, so gross profits are reduced by a number of factors to arrive at that number. These factors include:
- Depreciation or amortization
- Income taxes
- Interest expense or income
- Non-operating income and expenses
- Non-recurring income and expenses
When it comes to the SDE approach, it is important to understand that there are two components at play: the discretionary earnings themselves, and the SDE multiplier.
As outlined above, SDEs add non-essential expenses back into the equation (in addition to owner’s salaries and one-time expenses) to increase net income and demonstrate profit potential. Once this value is determined, the SDE multiplier comes into play.
SDE multipliers change from industry to industry and can be influenced by a variety of factors — with the risk being the most prominent. Multipliers typically run between 1 and 4, with 1 demonstrating higher levels of risk and 4 (or more) demonstrating high-profit potential.
A business that (1) provides services in an industry on the decline; (2) is located in an area that is struggling economically; and (3) which depends on the charisma of its owner to succeed would have a lower multiplier. Conversely, a business in an emerging industry located in a hot market would have strong prospects and therefore a higher multiplier.
The product of an SDE and its multiplier — minus liabilities — gives a clear sense of the value of a small business.
Knowing the Value of Your Business
Whether you are only just considering the sale of your business or are actively engaged with the project, it is important to have a team in your corner to help you through the process. Our team at Succession Resource Group has more than two decades worth of experience in valuing hundreds of businesses across industries. Contact us today for a consultation so that you can be on your way to an efficient, profitable, and successful sale.