How to value your business?
Today, we’re talking about business valuation. First, let’s define what business valuation is.
Business valuation is the process of determining the economic value of your business today.
There 4 methods of valuation we’ll be going over today:
- Book value
- Earnings multiplier
- Market value
- Discounted cash flow
Now valuing your business is not a black and white exercise as you’ll see. There’s a lot of gray areas.
Think of it like this…
If you go to Walmart and look at their TVs, you’ll see a wide variety and for the most part, all of those TVs have different prices. Some are $499, while others are at $699, $899, etc.
Obviously, the brand and size of the TV will help determine its price, but why don’t companies sell their TVs for $5,000? Or $10,000?
The reason is that no one would be willing to pay that price for it. And therefore, it is not valued at that price.
A large part of business valuation is determining what a buyer or investor would actually pay for your business.
Chances are if you are just starting out, struggling to get sales, and decided to sell your business a year from now… you likely won’t have any buyers if your sales price is $1M.
Unless there is some data to support that valuation.
So the first step is determining which valuation method to use.
Top 4 Ways to Value a Business
1. Book Value Method
The book value is derived by subtracting the total liabilities of a company from its total assets.
The book value approach may be particularly useful if your business has low profits, but valuable assets on file.
Assets are the resources in your business that help you earn sales – things like inventory or cash.
For example, if you have assets on your books valuing $100,000 and liabilities (or debt outstanding) of $25,000. The value of your business would be $75,000 under the book value method.
If your liabilities are higher than your assets, then you would have a negative valuation.
And essentially, your business would be considered worthless until you either pay off your debt or increase your assets.
The drawback to the book value method is that it does not consider a business’ future earnings potential.
After all, a lot of businesses don’t have a lot of assets but still earn high revenue.
And even a business with high-value assets could have more to offer than just the assets they have.
The book value method, though simple, may not paint the entire picture of your business’ worth.
2. Earnings Multiplier
The earnings multiplier method is based on the idea that a business’s value lies in its ability to produce wealth in the future.
The earnings or income of a business are used to value a business in this method.
But you can look at earnings in different ways, depending on what you include.
Do you include taxes? Do you include non-sales income like interest income?
In most cases, EBIT (Earnings Before Interest and Taxes) is the measure used as earnings. So take your revenue minus cost of goods sold and operating expenses.
To value your business using the earnings multiplier approach, you would need to evaluate your EBIT over a period of time, like over the past year.
You would then apply a “multiplier”. The multiplier is a number usually between 2 – 7 and it gets multiplied by your EBIT.
So if your earnings before interest and taxes were $300,000 and your multiplier is 3, you could reasonably value your business at $900,000. (300,000 × 3).
A large part of this method is figuring out what multiplier to use.
The most accurate way to determine what multiplier to use is to work with a business appraiser.
They take into account a number of different factors to determine your multiplier, such as:
- business size
- market trends
- business brand
You could also search “multipliers by industry” on Google to see the most current information on multipliers for your particular industry.
3. Market Value Method
The market value method determines the value of a business based on the selling price of similar businesses.
Regardless of the type of business being valued, the market value method studies recent sales of similar businesses, making adjustments for the differences between them.
For example, when valuing a retail store, adjustments might be made for factors such as the number of inventory on hand, foot traffic, and location.
So for example, if other retail stores have recently sold for $750,000 in your area, it is likely that, with all else being equal, your retail store is valued somewhere near that number.
However, there are limitations with the market value method such as:
- You may not be able to find comparable sales.
- If the sale data isn’t recent, it may not reflect the current market value.
- This method only works for businesses that can access sufficient market data on their competitors.
4. Discounted Cash Flow Method
This is a valuation method used to estimate the value of a business based on its expected future cash flows.
Discounted cash flow method or DCF method attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.
The purpose of DCF analysis is to estimate the money an investor would receive from an investment or business, adjusted for the time value of money.
The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested today and earn interest.
Think about it, if someone offered you $1M right now or $1M five years from now, which one would you choose?
$1M today! Who knows what will happen in 5 years so you would take the money today.
So going back to the DCF method, in order to conduct a DCF analysis, an investor must make estimates (or projections) about future cash flows and determine an appropriate discount rate.
The discount rate is what determines what $1 in the future is worth today.
As we discussed, a $1 today is worth more than a $1 tomorrow. Or vice versa, $1 tomorrow is worth less than $1 today.
So if the projected cash flows of your business is $100,000, under DCF, a discount rate would need to be applied to figure out the value of that $100,000 today.
And therefore the valuation of your business today.
The discount rate is a company’s weighted average cost of capital.
The WACC is a complex formula.
However, there are online calculators to help you determine your WACC.
Once you have your discount rate (or WACC), you would apply it to your company’s cash flow projections and it will give you the value of your business today.
Advantages of DCF
- It doesn’t require competitor/market research.
- You can incorporate your assumptions and expectations about the future of your company into a DCF calculation.
Disadvantages of DCF
- You use assumptions about future growth and cash flow. It’s tempting to make them overly optimistic.
- Changing your assumptions can create radically different future cash flows.
- Figuring DCF is a complex approach.
Now you know the different business valuation methods. We hope we didn’t confuse you too much.
Ultimately, we would recommend you hire a professional to value your business.
As a business owner, it’s easy to overvalue your business. And having someone else do it would reflect a more objective valuation. If you need help with this, contact us today!