How do I value my business?
”How much is my business worth?”; “I’m selling my business how much is it worth?”; “How much can I sell my business for?” ; “How much should I sell my business for?”
For many small business owners, these are a few of the common questions asked, when considering retirement, succession, or exit planning.
While the true value of a business is ultimately what a willing buyer will pay, it can be helpful to start with a fundamental understanding of business valuation.
Though many factors can significantly influence the value of a business, these factors can be distilled into two key elements:
How much cash the business generates (the higher the cash flow, the higher the value), and
How risky the business is (the higher the risk, the lower the value).
Cash flow is usually easy to understand, however assessing risk can be more complex. Factors like competition, reliance on key customers or suppliers, and how often revenue repeats, are used to evaluate your business’ risk profile.
That being said, there are three general approaches that can be applied to valuing any kind of business, which inherently capture these two fundamental elements of business valuation. We’ll dive into each of them below.
Market Approach
Cash Flow Approach
Returns Approach
Market Approach
The market approach approximates the value of a business by answering the question of ‘how much would a similar business be worth?’
To do this, business brokers or appraisers will look for transactions involving businesses with similar characteristics—typically based on business industry and size—to calculate what is called a valuation multiple.
A valuation multiple is simply the ratio of the price paid for a business to a measure of its earnings. Put another way, a valuation multiple answers the question of ‘how much is someone willing to pay, for $1 of my earnings?’ Think of this as being similar to the price-per-sqft metric you often see in property transactions.
Common measures of earnings used under the Market Approach are Revenue, Earnings-before-interest-tax-depreciation-and-amortization (‘EBITDA’), and Seller Discretionary Earnings (‘SDE’).
For example, if ‘Revenue’ is used as the business’ measure of earnings, and similar businesses generating revenues of $100K have recently sold for $1M, a valuation multiple of 10x would be applied to your business’ Revenue to estimate its value.
The Market Approach is seen as a simple, short-hand approximation for the Cash Flow Approach, and is the approach most commonly applied in small business valuations.
Cash Flow Approach
Under the Cash Flow Approach, a business’ value is calculated by ‘discounting’ its future cash flows, to arrive at a ‘Net Present Value’.
To do this, a business broker or appraiser will first look to create a detailed forecast of the future cash flows which will be generated by the business. This exercise commonly involves projecting the business’ revenues, expenses, capital expenditure, and working capital over a future period of time.
These cash flows are then discounted back to the present at an appropriate rate, which reflects the inherent risk of the business. This is to account for the fact that a dollar received today is less risky, and therefore worth more, than a dollar received tomorrow.
To illustrate, if your business is expected to generate $100,000 in cash exactly one year from now, and the appropriate discount rate is 10%, the Net Present Value of that $100,000 cash flow is $90,909 or [100,000 ÷ (1 + 10%)^1].
In practice you’ll often hear this referred to as a ‘Discounted Cash Flow’ analysis, or ‘DCF’. This approach is not commonly used in small business valuations as it is heavily sensitive to the assumptions made around the business’ growth and profitability—which can be relatively hard to predict.
Returns Approach
The Returns Approach can be used to estimate business’ value by answering the question of ‘how much could a buyer pay, in-order-to maintain an attractive return on their investment?’
To do this, a business broker or appraiser will put themselves in the shoes of a potential buyer, apply conservative assumptions to project the cash flows generated by the business, and calculate the minimum and maximum purchase prices that would generate an attractive return.
Although what constitutes an ‘attractive’ return varies with the risk of the investment, a reasonable range for a small business investment would be 25-40% p.a. (as measured by the Internal Rate of Return—a common measure of financial return).
While the Returns Approach is similar and related to the Cash Flow Approach, it has the advantage of being relatively more ‘assumption free’, allowing for a conservative estimate of the business’ value to a potential buyer.
This approach is most commonly used by financial buyers such as private equity firms, or search investors, and is less commonly seen in small business valuations. It can still, however, provide a very useful indication of the range of potential prices which a buyer may be willing to pay for your business.
In Summary
There are three main approaches to valuing any business—each of which seek to capture the cash flow generation and inherent risk of the underlying business. In practice, an appropriate combination of these methods will typically be used to form an estimate of your business’ value.
The Market Approach is the most simple and commonly applied methodology in small business valuations. The Cash Flow Approach requires the most detailed forecasts and projections, and (for this reason) is least commonly adopted. The Returns Approach is typically used by financial buyers, but can provide a very useful indication of the range of prices which a buyer may be willing to pay.
At DealNavi, we’ve worked with some of the world’s most experienced business brokers and business value appraisers to develop a fast and accurate valuation process. Click here to see how we can help you today.