How to Value a Business & Common Mistakes to Avoid
– How to Value a Business –
Determining a company’s fair market value is a challenging job. You can figure out a company’s economic worth by applying a variety of measurements.
In this post, we’ll go over all you need to know about how to value your business, why you should, and how to avoid common pitfalls.
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What Is Business Valuation?
Business valuation can be described as the process or result of determining the economic value of a company. All businesses have one thing in common: The goal is to generate profits for shareholders.
Time frames, methods, and expectations differ, but the goal is the same. Ultimately, the value of any business is the present value of expected future profits.
The valuation process looks in depth at the operation, expenses, revenues, strategy, and risks of the business to arrive at assumptions for future earnings, time horizon, discount rates, and growth rates.
Valuation vs Pricing
All business valuations are estimates. The objective of the valuation, and who does the analysis, heavily influence the end result.
Investment bankers valuing a company to take it public want to justify the highest number possible, while accountants valuing a company for tax purposes want to arrive at the lowest number possible.
Valuation is different from the pricing. Valuation is intrinsic; it’s based on the actual performance of the business.
Pricing results from supply and demand; it incorporates market influences such as the overall direction of prices, other investors, and new information such as rumors and news.
Why You Would Need To Do a Business Valuation
For an owner who may be looking for financing, considering a sale, or updating a financial plan, here are some common reasons for a business valuation.
1. Merger, Acquisition, and Financing Transactions
Valuations are fundamental to negotiations for the sale, purchase, or merger of a business. Valuations are used to benchmark buy-ins and buy-outs for partners and shareholders.
Lenders and creditors often require valuations as a condition for financing. Valuations are also used to establish and update employee stock ownership plans (ESOPs).
2. Tax and Succession Planning
Valuations determine estate and gift tax liabilities and have an important role in retirement planning. Tax and succession valuations follow IRS guidelines.
Valuations are also often central to divorce proceedings, resolving partnership disputes, and settlements for legal damages.
4. Strategic Planning
The in-depth analysis of a business valuation can help owners better understand the drivers of growth and profit.
What Affects Business Valuation?
While there are some parts of a business you can value easily, there are always going to be intangible assets.
Beyond stock and fixed assets (like land and machinery), which are tangible and have clear value, you should also look at:
the business’s reputation
the value of the business’s customers
the business’s trademarks
the circumstances surrounding the valuation (like a forced sale rather than a voluntary one)
the age of the business (consider startups making a loss that have lots of future potentials, versus established profit-making companies)
the strength of the team behind the business
what kind of product do you have
These intangible assets make it fairly difficult to reach an accurate valuation, but there are a number of techniques you can use to make it easier.
Business Valuation Methods
The valuation method used depends on the condition of the business and the purpose of the valuation. The discounted cash-flow method is generally used for healthy companies generating a profit.
1. Discounted Cash Flow
The discounted cash flow method determines the present value of future profits or earnings. The discount rate reflects the potential risk of the business not meeting profit expectations.
A higher discount rate results in a lower value, which reflects a greater risk posed by the business. There are variations of the discounted cash flow method that use dividends, free cash flow, or other measures instead of earnings.
The discounted cash flow method usually calculates the present value of five years of earnings adjusted for growth and future earnings beyond five years (known as terminal value).
2. Net Asset, or Book, Value
The net asset value, also known as book value, is the fair market value of the business assets minus total liabilities on its balance sheet.
Investors and lenders will consider net asset value for younger companies with limited financial histories. Net asset value is also useful as a lower limit for a valuation range, as it only measures a business’s tangible assets.
3. Liquidation Value
Liquidation value is the net asset value discounted for a distressed sale. Investors and lenders may consider liquidation value for younger or potentially distressed companies.
4. Market Value
The market value method is a relative method. It compares a company with its peers and within its industry to arrive at a value by using multiples like price-to-earnings ratio (P/E).
For example, one could value the Really Cool Fans Co. by applying an average P/E multiple for appliance stores to the company’s earnings like this:
Value = Price / Earnings Multiple 25 x earnings $120,000 = $3,000,000
The problem with using a relative method is that it incorporates any errors the market makes in valuing comparable companies as well as in the overall direction of prices.
What Business Valuation Means to Investors
Valuing a business is a complex process, and there aren’t any shortcuts. For the average investor, research reports can offer insights into a company’s value. The business valuation process is an in-depth analysis, yet at the same time, it’s only an estimate.
A basic understanding of the valuation methods, however, can help you clarify your investment philosophy and strategy. A true value investor analyzes stocks independently of the market and looks for gaps between value and price.
They believe that over time, the price will catch up with value. Price investors look for market trends in the demand for a stock using technical analysis, then try to get ahead of those trends.
Efficient-market investors believe the market accurately reflects value. Value and price investors use active management styles, by selecting specific stocks with a goal of outperforming the market.
Efficient market investors use passive investment styles, such as index funds.
What Makes A Business Valuable?
The amount a buyer is willing to pay for your business will all come down to two things, return-on-investment (ROI) and relative risk.
The lower the risk, the higher the price, and vice versa. With that being said, what really makes your business worth more when selling is mitigating the risk of the business failing in the future by having the following characteristics associated with your online store:
- Predictable key drivers of new sales
- Stable or growing traffic from diversified sources
- Established suppliers with backup suppliers in place
- A high percentage of repeat sales
- High percentage of repeat customers
- Clean legal history
- A brand with no trademark, copyright, or legal concerns
- Documented systems and processes
- Growth potential
Common Mistakes to Avoid when Valuing a Business
1. Don’t Confuse Assets with Value
A company’s value isn’t the same as the value of its total capital assets. When someone wants to buy your business, they aren’t planning on selling your office furniture or computers.
Instead, they want to know how much revenue and profit the company will generate and how much of a salary they can take as CEO.
While total capital assets may play a role in your business valuation, your company’s value is more complex than that.
2. Don’t Forget to Adjust Forecasted Profits
When calculating your expected profits for the upcoming years, you have to adjust those profits for market conditions, customer demand, and simple fluctuations. No business makes the same profit every year.
A solid financial history can help you create a better profit forecast, but you also have to consider expenses, market fluctuations, increased or decreased marketing budgets, and so on.
3. Don’t Forget to Calculate Required Working Capital and Expenses
Building on what we said in the previous paragraph, you have to consider how your expenses will vary from year to year and whether you will have the working capital required to continue operating your business.
You’ll have to forecast they will tie how much of your assets up in non-working capital, such as accounts receivable.
4. Don’t Be Over Optimistic, and Remember to Calculate Risks
If you want to get a truly accurate business valuation, you can’t be overly optimistic about your forecasted profits and growth.
In addition, you need to calculate potential risks, as they will affect your company’s value.
5. Use Proper Multiples
When valuing the forecasted profits of your business, it is crucial to use the correct number of multiples.
In other words, how many years can you expect your company to stay in business? If it’s 10, and your profit per year is $100,000, your business may have a value of $1 million (that’s a very simplified statement, though).
Every industry will have a different standard, but it also depends on the size of your company, how many years you have been in business, how much working capital you have, your forecasted profits, and other factors.
A small, family-owned business may have an expected multiple of 2-10, while more established, giant corporations may have multiples many times that amount.
6. Understand that Valuations Aren’t Set in Stone
Valuations can and do change over time. Just because you got your business valued a year ago, that doesn’t mean the same projected value is valid now. Since business valuations take so many factors into account, valuations can fluctuate.
Also, remember that your company’s value may be a range between a lower and higher value.
That’s because certain risks are harder to quantify, and the final value may depend on the buyer’s risk tolerance. In addition, the urgency of the sale and your relationship with the buyer can also affect the rate.
7. Don’t Attempt to Do a Valuation Yourself
This mistake is common. There are so many variables you need to consider and so much data to look at that doing a valuation yourself often leads to trouble.
In addition, there is more than one valuation method, and it is vital to use the right one for your industry and business size. One common pitfall is mixing valuation methods and ending up with inaccurate results.
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Where Can I Sell My Business?
1. Broker – ($250k – $5m in profit businesses)
Medium-sized businesses are best sold through brokers who help with selling your company. Best for businesses making between $250,000 and $5m in profit per year.
2. Marketplaces – (under $250k profit businesses)
Smaller businesses and micro-businesses are usually best sold privately by the owner through forums or marketplace websites.
3. Investment Banks – ($5m and over profit businesses)
Larger businesses are best sold through investment banks or merger and acquisition companies.
Tips For Sellers
If you’re looking to get a business valuation so that you can sell your business, then you’ll likely want to know how to maximize the sale price.
Our top three tips to help you maximize the value of your business are:
1. Prepare for the Sale
Start preparing long before you put the business up for sale. Get your books in order and make sure there aren’t any accounting or reporting mistakes.
These can slow down the sale process, and make it difficult to maximize your value. The fewer things that look wrong when your business is analyzed, the easier it will be to get to closing.
Also, when you’re ready to sell, make sure you have the right documentation ready to go before approaching a business broker.
This will speed up your process and give the broker more confidence that they can count on you being ready when you need to provide more information to them later. The documents business owners should have ready are:
- 2+ years of business tax returns
- Current P&L (profit-and-loss statement)
- Current balance sheet
2. Use a Business Broker
Using a broker not only will set your expectations at an acceptable level, but it could also make or break your entire sale. An experienced broker will be able to maximize the value in your sale and get you the largest sum possible for your business.
Brokers are often able to get much larger sale amounts than you’re able to get on your own. Choosing the best business broker for your situation also takes away many of the headaches that would otherwise fall on you.
Try outsourcing to a business broker so they can handle the administrative work, marketing your business for sale, communications with potential buyers, and negotiating both sales prices and final contract terms.
One consultation will provide you with answers to questions like:
- What is my business worth?
- Can the valuation price be increased?
- How long will it take to sell my business?
- What’s the next step?
Meanwhile, you can stay focused on operating your business, and continuing to maximize its value until it’s time to sell.
3. Don’t Let Your Emotions Impact the Sale
Your business can feel like an old childhood friend, or even a family member, because of the amount of time you’ve spent working in it.
You’ve likely poured your heart and soul into making the business what it is today. However, according to Jock, “The market is the market.”
This means that your business is going to get the value that the market dictates based on your performance, the current economy, and the industry.
Being emotional about what potential buyers value your business isn’t going to help you get to closing. Put yourself in the buyer’s shoes and don’t get emotional if you want a smooth sales process at a maximum price.
Tips For Buyers
Buying a business can often be even more complicated than selling, because you may not be familiar with the industry or business which you’re buying.
Many buyers start out with no clear understanding of the type of business they would like to own and wind up doing research on the fly.
Buyers should research industries that they are interested in to determine future potential while avoiding contracting markets.
The three tips to keep in mind as you look for the right business to purchase are:
1. Find an Industry with Potential
While you may pay more for a business in an industry with high multiples, it’s also more likely to hold its value.
This means that when you’re ready to sell the business in the future, you should still be able to get a higher sales price for it, especially if you choose an industry with high future growth potential.
2. Ask for Seller Financing
Seller financing is when the seller gives you a loan for part of the purchase price.
This can lower the financing amount you need to close the transaction, and you’ll typically get it at a cheaper cost than you would if you received a business acquisition loan for the whole purchase price.
Seller financing is common for small business transactions, but you should determine early on in the process whether it’s available from the seller.
3. Hire a Business Broker
Hiring a business broker is not quite like hiring a real estate agent. The seller compensates brokers, and may not have an incentive to work with buyers directly, preferring instead to let buyers choose the listings they’re interested in.
A good business broker can also access many more business opportunities than you can by yourself due to their experience and extensive network.
A good place to start is with a nationwide business broker network, where listings are shared between brokers across the country.
Some brokers may charge an upfront fee for assisting buyers, and in return provide valuation and negotiation services, in addition, to helping to find the right business.
Pros of Using a Business Valuation Calculator
Using a business valuation calculator is a fast and simple way to get a ballpark value of a business without hiring an expert and with minimal effort; however, it’s not without its disadvantages.
Our business valuation calculator doesn’t factor in tangible and intangible assets which can both significantly impact a business’s actual value.
Some of the pros of using a business valuation calculator are:
- Quick and simple: A business valuation calculator can be used as a quick and easy tool to ballpark a business’s value, which can be especially useful when comparing many like businesses to each other.
- Valuation varies by industry: Most business valuation calculators include an average industry multiple in the calculation, which is useful as not all industries have the same risks and opportunities, which can significantly impact a business’s value.
- Based on revenue and profits: By focusing on actual revenues and profits generated by a business, valuation calculator is based on a business’s bottom line, which is how much money a business generates notwithstanding assets and liabilities.
Cons of Using a Business Valuation Calculator
Some of the cons of using a business valuation calculator are:
- Doesn’t include assets: Our valuation calculator excludes tangible and intangible assets, which can make up a significant portion of the actual value of a business in asset-heavy industries. It should be combined with a valuation method that includes assets.
- Not a market-based approach: For some businesses, bullish market trends may indicate a much stronger valuation. Conversely, for businesses operating in a contracting market, this approach may over-inflate the value of the business’s future revenues.
- Excludes expert analysis: The biggest flaw in any math-based valuation method is the absence of expert analysis. No two businesses are exactly alike, and a math-based calculation ignores factors like intangible assets and year-over-year growth.
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Frequently Asked Questions (FAQs)
1. Is the Date of a Business Valuation Important?
Yes, valuations for financial reporting and tax purposes have to be completed by a deadline. Valuations for mergers and acquisitions, financing, and other transactions have to meet the requirements of the parties involved.
2. What are the Elements of a Business Valuation?
A business valuation can be thought of in terms of “why,” “how,” and “who.”
- Why is the objective of the valuation? Valuations done for different purposes will probably yield different results.
- How is the valuation method selected? Different methods will produce different results.
- Who is the person or firm performing the valuation? Their experience and philosophy will influence the results.
3. How Do You Value a Business Based on Turnover?
Business turnover is when you work out your business income over a set period (for example the tax year).
This is the number of sales you’ve made–also known as the ‘net sales’ figure. However, this mustn’t be confused with profit, which is your earnings after deducting expenses.
Calculating turnover is a useful step to understanding the health of your business fairly quickly, but will need to be compared to gross profit and net profit to give a full picture.
4. How Much is My Business Worth?
As we mentioned earlier, valuing a business can help you focus on areas for improvement. There are lots of things you can do to help secure a good valuation, including:
- planning ahead: have a solid business plan, with a focus on how you’re going to achieve both short-term and long-term results
- reducing risk: for instance, if you rely on a particular group of customers, consider diversifying
- Putting great processes in place: think about how you store information, whether its financial records or simply how the business works. Often, the more you can show, the higher the confidence in the business.
What works for one business won’t always work for another. By giving an overview of several popular business valuation methods, though, we hope you’re closer to understanding how much your business is worth.
The most important thing in a business acquisition, whether you’re a buyer or a seller, is to arrive at a fair price for the business. This involves several factors, and this article has successfully tried to point them all out.
If this article was helpful to you, do well to share it with others, as this might be helpful to them as well.