Whether you plan to buy a business or sell a business that you already own, understanding how to value a business is key. You don’t want to overpay for a business you’re acquiring. As an owner, you don’t want to miss out on value owed for a business you’re selling.
In this article, I’ll summarize the five primary ways to value a business.
Important to business owners – there are also multiple ways to increase the value of a business. Some of the factors that impact the value of the business are consistent regardless of the valuation type. Other factors depend on the type of valuation performed. That’s a topic for another day, but keep it in mind as you start to consider your transition.
Five Primary Methods to Value a Business
Let’s dive into these five business valuation methods.
Valuation based on the value of the assets
This method looks at everything the business owns.
Consider the inventory, supplies, office furniture, real estate, etc., and total up the value of all of those assets. Then total any debt owed on these assets or that might be owed by the business in general. Finally, take the total asset’s value and subtract the total outstanding debt.
This method helps determine the value of the business if sold in liquidation. Your business likely has value beyond it’s “breakup value” so this should be considered a low-end estimation of value.
Assuming the business has decent financial records, you can get a pretty good idea of what this value would be by looking at the balance sheet. If the business does not have decent financial records you should probably think long and hard about whether it’s a business you would want to purchase at all.
What matters to most people purchasing a business is how much revenue and profit can be generated by the use of the assets. Those financial metrics are key in the next three valuation methods.
Top-line revenue-based business valuation
Another way to value a business is to consider the total revenue the business is generating. Whether or not this valuation method is appropriate depends on the industry type and the intent of the purchaser.
Example: Let’s say your business currently generates $1 million dollars of annual revenue. A purchaser using this method might make an offer of 2.5 times revenue. In this case, their letter of intent might reflect a purchase price of $2.5 million dollars.
The most common way I see this type of valuation used is when the purchaser is going to pull revenue into their existing business without the overhead or the expenses the acquired business currently has to deal with.
This valuation method ignores whether not the business is profitable. This could be good for you as an owner if your margins are thin. But if you have nice margins and are highly profitable you might want to encourage the use of other business valuation methods.
As a purchaser, you would run financial projections to determine how the additional revenue would impact the profitability of your existing (acquiring) business.
Note: this type of acquisition is often structured as an asset sale. A different article will discuss the pros and cons of an asset sale versus stock sale. You definitely need to understand that topic because it can have a drastic impact on taxes for both the seller and the purchaser.
Valuation based on bottom-line profit
This valuation method is extremely focused on the business’s profits. The more profitable the business, the higher the valuation will be.
Example: Let’s say your business currently has annual profits of $400,000. A purchaser using this method they might make an offer of 6 times profits*. In this case, their letter of intent might reflect a purchase price of $2.4 million dollars.
*More commonly used than profits would be EBITDA. That stands for Earnings Before Interest Taxes Depreciation and Amortization. Since the buyer and seller might have different tax and accounting circumstances, this method helps standardize the calculation.
The purchaser in this scenario generally plans to keep the business intact. Because of this, they are mostly concerned with profits currently generated – and potential profits for the future.
Investors in public companies often use this valuation method.
You commonly hear the term price-to-earnings ratio. The price-to-earnings (P/E) ratio is the value of the business compared to the business’s profitability. For example, if the P/E ratio is 20, and the business profits are $125,000 per year, the value of the business would be $2.5 million.
If using this method to value your business you can look for public companies in the same industry to review their price-to-earnings ratios. That will give you an idea of ratios you might consider reasonable for your own business valuation.
Using future cash flows to value a business
Another, generally more conservative, method of valuation would be based on future cash flows. The rather complex “discounted cash flow” calculation is often used to derive a fair value in this case. This financial calculation looks at the current and future expected cash flows and how that would impact the value of a business in today’s dollars. This is a method commonly used by investor Warren Buffett when he is considering how much to pay for a business.
There are quite a few challenges with this method of business valuation though. As an example, consider the following unknowns that come into play:
- For how many years should you consider future cash flows?
- At the end of that period, what would be the residual value of the remaining investment?
- How might the cash flows change in the future – up or down?
- What impact will inflation have on the value of the cash flows?
Just to name a few!
Nonfinancial considerations when valuing a business
At the end of the day, what an asset is worth equals what sellers are willing to sell for and what buyers are willing to pay for it.
Some transactions will start with one of the valuation methods above and then make adjustments for nonfinancial factors.
Situations to considered include:
- If the business aligns and complements an existing business the buyer owns.
- Perhaps the business is in a location that is extremely attractive to the buyer.
- Maybe the buyer just absolutely loves something about the business beyond the numbers and strongly desires to own it.
Deciding on a business valuation method
Oftentimes there is one business valuation method that is most common for a business in a certain type of industry. Even then, I would encourage sellers to perform analyses using multiple methods to see how they compare.
As noted earlier, there are also ways to increase the value of your business. Some of these are financial adjustments and others are nonfinancial. These adjustments often take time but lead to a win-win that brings in a higher selling price for the owner while retaining a very fair value for the buyer.
When you are two to five years out from a potential sale you may want to consider working with a financial advisor that specializes in financial planning for business owners. You might even consider working with someone before a sale is on the horizon. Why not position yourself and your business to take advantage of an opportunity in case it was to arise?
If you’re a business owner interested in talking more about this just schedule a complimentary call to chat about your situation and how we might be able to help.