How To Value A Business?

Business Valuation

If you are a business owner and ever thought about selling your business, you would have wondered how to value a business. Business valuation is part art, part science and the more proficient the balance you have in these two, the closer you can get your selling price to your valuation price. We have several valuation methods available to us to help us pin point the valuation range. Head to Evaluate Advisory if you want to learn in more detail about the industry best practices in business valuation methodologies for private enterprise.

In addition to determining how to value a business, you need to be aware of other value drivers as well. For example, “How much will a buyer, in this current market conditions, with current interest rates, be willing to pay for my business?” You see, sellers may have their own perceived value using their own value drivers, and the bottom line is if the bottom price of the seller and the buyer do not overlap, there is no market and transaction. The same principle is applied to any other asset for sale in any market. That is where the common saying goes “Willing buyer, willing seller” and you have a market. These two form the internal (business specific) and external (market conditions) factors that determine what your business is worth.

That being said, to come up with preliminary price value for a business, we can use several methodologies available to us today. Here is a list of some common valuation methods. Scroll down further to see detailed explanations for methods on how to value a business.

 

Business Valuation Methods

1) Discounted Cash Flow Analysis
2) Multiples of earnings: EBITDA and Seller Discretionary Cash Flow (SDCF) or Seller Discretionary Earnings (SDE)
3) Market Transaction Comparisons
4) Fair Market Value of Asset (Liquidation method)


Factors Affecting Value

a) Deal structure (Asset vs Share sale, Seller Financing)
b) Minority discount (if you own shares in a company that does not give you controlling stake)
c) Tax incentives and impact
d) Business seller urgency
e) Positive or negative industry changes
f) Interest rates

 

1. Discounted Cash Flow Analysis (DCF)

The discounted cash flow analysis of a business is a great tool for businesses that have a proven track record and is anticipated to carry on business toward the future. This formula takes all the future cash flow earnings of a company, and discounts (adjusts) them to today’s value. The two fundamental factors in this model are time value of money and present value.

The general rule of thumb is to project your expected earnings not more than 3 – 5 years out, and discount them to today’s present value. You also add a terminal value (TV) to determine the value of the cash flow component from year 5 and beyond. Popular methods are the Gordon Growth Model or the Exit Multiple Model.

The total valuation formula of the cash flow method is:
(Present Value Cashflows Year 1-5) + (Present Value of Terminal Value)

Here are the formulas for two methods for Terminal Value:

Gordan Growth Model
Terminal Value = Cashflow / (Discount rate – growth)

Exit Multiple Model
Cashflow * Multiple
(due to the large degree of variation between the discretion e.g. using a 5 or 10 multiple, the Gordon Growth Model is used more often)

 

A. Example of DCF using Gordon Growth Model

Discount Rate: 25%
Growth Rate: 4%
Cashflow: EBITDA

Terminal Value at year 6 = $750,000 / (0.25 – 0.04) = $3,571,429

Year +1 Year +2 Year +3 Year +4 Year +5 Terminal V. TOTAL
Cashflow  $550,000  $570,000  $600,000  $670,000  $710,000 $3,571,429
PV Today  $440,000  $364,800  $307,200  $274,432  $232,653  $936,229  $2,555,313

 

B. Example of DCF using Exit Multiple Model

Discount Rate: 25%
Growth Rate: 4%
Cashflow: EBITDA

Terminal Value at year 6 = $750,000 * 5 = $3,750,000

Year +1 Year +2 Year +3 Year +4 Year +5 Terminal V. TOTAL
Cashflow $550,000  $570,000  $600,000  $670,000 $710,000 $3,750,000
PV Today $440,000  $364,800  $307,200  $274,432 $232,653  $983,040 $2,602,125

 

2. Multiples of Earnings

The most straight forward method to valuing a business is the multiple of earnings method. While the simplicity of using a multiple to earnings is enticing, it is deriving the multiple that is the tricky part.

First, let’s see what some terms mean:

SDCF (SDE):

Seller Discretionary Cash Flow and Seller Discretionary Earnings mean the same thing. I will refer to these as the SDCF. They are used when valuing smaller owner operated businesses which usually have earnings of less than $500,000. The SDCF is the pre-tax profits of a business and adding back of all the non-operating, non-cash expenses and owner benefits. Small businesses are usually run for tax optimization and it is common practice for owners to expense benefit items like automobile, mobile phones, some travel under the company’s expenses. To get a SDCF, we add back all these to get a true picture of the actual profit of the business without owner compensation.

EBITDA:

This accounting term means the pre-tax profits of the company, plus the interest, taxes, depreciation, and amortization all added back. It gives a true income performance of a company less non cash impact like depreciation, tax optimization strategies, and financing/leverage strategies. EBITDA is used as a performance measure of typically larger and more established firms. They often do not require the owner to be actively involved in the day to day running of the company. I generally categorize it as the company is big enough to hire its own CEO to run it.

Multiple:

This is the multiplier number that is used to multiply either the SDCF or the EBITDA of the most recent year or the historical weighted average. This method is straight forward and it is clear to see how the business is priced.
For example, if we used a 2.5x multiple for SDCF and the SDCF was $250,000 the business would be valued at $625,000.
It looks simple and straight forward at first, however, the key to getting a more accurate multiple is more complex. There are methodologies used to adjust the multiple to account for different value drivers and this will be where more experienced professionals who have industry experience come in.
The rule of thumb for multiples of small business earnings less than $400,000 would be between 1-3x SDCF. As the company earnings get larger (above $500k), we start to look at EBITDA and the multiples begin to get higher.

 

3) Market Transaction Comparison

We could also use comparables that have sold in the past to value a business. This method cannot stand alone and has to be used in conjunction with other methods but it is a very good value driver to have. Referencing market comparables with historical transaction data is the most relevant value driver you can have because a real transaction took place. Nonetheless, we all know no two businesses are alike and the challenge comes when comparing two businesses that are similar but not identical. Using market transaction comparisons from industry reports help in adding strength to a valuation report. In this aspect, the $1,000 industry report purchased adds a solid foundation and manages expectations.

 

What’s the most accurate method to value a business?

Valuing a business is part science, part art. Just a little tweak to some key numbers or multipliers can throw the final figure off whack. There is no exact number but there will always be a range. As a seller of your business, you give your asking price and then defend that number with your valuation methodologies. Buyers will have their own models, many are similar with different variables. At the end, a transaction takes place at a point where both your numbers converge.

Don’t worry if this all sounds foreign to you. If you want a professional opinion of value that you can rely on, head to Evaluate Advisory.

 

 

WHAT IS YOUR BUSINESS WORTH?

Up to 8 Methodologies Used:

1. Income approach: 3 methodologies.

2. Market approach: 3 methodologies.

3. Asset approach: 2 methodologies.