A Quick Summary of the Why and How of Valuing Your Business
Understanding the value of your business is crucial. This is true whether you are looking to raise funds to expand, admit new partners, incentivize key employees, or retire and capitalize on your hard work and effort. While not as easy to measure as a bank account balance, understanding the value of your business may prove vital to appropriately planning for your future.
How to Value Your Small Business
Business valuation can be quite simple or highly complex depending on how accurate the estimate needs to be. For a basic indication of value, you’ll first need to understand your earnings. This may mean any number of things, so its important to clarify. Large Public companies tend to look at Net Income (using terms such as earnings per share), but for many small businesses, Net Income becomes a bit less reliable of a measure. A more nuanced version of earnings will probably be more appropriate depending on your business.
For example, you may want to consider Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) as a good measure of cash flow in the business. Many investors will consider this measure of profitability when determining pricing multiples. Another important measure for small businesses is Seller’s Discretionary Earnings (SDE). This starts with EBITDA, but includes an adjustment for any salary, bonuses, or costs incurred by the current owner. The SDE would represent the amount of money that would be available to a new owner (assuming they take over as the new manager/operator of the company). Once you have an understanding of your earnings metrics, you’re ready to apply one of the two primary valuation methodologies for small businesses — the income approach and the market approach
The income approach to valuing a business typically utilizes a Discounted Cash Flow (DCF) analysis which is based on the concept of the time value of money. This is to say the current value of a business is based on its expected future cash flows (EBITDA). To determine the fair value of your business using this method, you’ll need to create a forecast of your cash flows for the next five to ten years into the future. Next, you’ll determine how much those future earnings are worth today by discounting them back to the present at a rate representing the riskiness of the business. This rate varies depending on several factors including, stage of the business, industry, capital structure, etc. A sum of the discounted cash flows represents the current fair value of your company. If your company has stable earnings every year, then specialized versions of the DCF may be more appropriate, such as the capitalization of earnings method.
The market approach to valuing a business evolves from the comparison between your business and other similar businesses in your industry that have recently sold. First, you’ll need to aggregate data from online data providers, such as Pratt’s Stats, on recent transaction activity within your industry. The rest of the approach is simple; the transaction data will include multiples, a value by which you would multiply by the relevant metric to arrive at the total current value of your business. For example, similar businesses in your industry may be selling for 2.0x to 4.0x their SDE, which would mean a business with $200,000 in SDE would be worth $400,000 to $800,000 in total. If specific transaction data isn’t available, many industries have rules-of-thumb that determine a reasonable range of multiples. However, each rule-of-thumb will be useless in a different industry due to the nature of clientele and cashflows. Additionally, multiples are often not enough, and each industry has nuanced approaches to calculating a value, such as adding in inventory after applying your multiple.
As you can imagine, the different valuation approaches can vary widely depending on a myriad of factors. This is why having a qualified business valuation specialist assisting you can be a game-changer. If you are trying to plan for taxes, or strategize for future growth, or you are looking to maximize value so you can get the most out of your retirement, a credentialed expert in the area of business valuations can help answer questions and set the course toward future success for you and your business.
Scalar is the leading independent valuation firm for tax, financial reporting, transaction advisory, and litigation purposes. Scalar empowers business leaders to make informed and effective decisions through meticulous valuations, insightful consultations, and active client engagement. Founded in 2009, Scalar is a world-class financial firm that combines the highest level of service and quality with the energy and efficiency of a startup. Scalar’s experienced team recognizes every client’s situation is unique and works tirelessly to refine and apply the most effective methodologies when performing valuations, calculating risk, and uncovering business opportunities to help clients plan for success. scalar.io
This guest blog is part of our National Small Business Week (NSBW) series. NSBW recognizeS the critical contributions of America’s entrepreneurs and small business owners. This year the Salt Lake Chamber is honoring the extraordinary accomplishments, determination and dedication of small business owners in Utah. Click here to learn more.