You may want to know the value of your business for several important reasons. For example, you may be approached by an interested buyer, you may plan to sell the business in the near future, or you may want to establish a value for insurance purposes (e.g., replacement costs of losing your business from a fire). What a potential buyer will pay for your business generally depends on two key factors: return on investment (ROI) and relative risk. A more favorable ROI and lower business risk may command a higher sale price and vice versa.
As an entrepreneur, you probably have poured a significant amount of time, money and sweat equity into creating and growing your business. ROI is a measure of how much value or additional money you have earned — your return or net profit after you pay all your business expenses (taxes, rent, salaries, etc.) — as a percentage of your beginning investment. The basic ROI formula is:
ROI (%) = (Return/Original Investment) x 100%
For example, let’s assume your initial investment in the business is $100,000, and your net profit (or return on your original investment) is $20,000. Then your ROI would be 20%:
ROI (%) = ($20,000/$100,000) x 100% = 20%
What may be considered a favorable ROI, however, should also be balanced with risk. Generally, when an individual is taking on considerable risk in buying a business, the potential ROI also should be higher to compensate for the relatively high level of risk the new owner is assuming. Buying higher risk investments that could potentially earn you more money may also decrease in value over time because of their volatility. A new buyer of your business needs to be comfortable with the balance between your current ROI and risk of assuming ownership. A 10-year-old restaurant with increasing profits over the past five years may involve less risk for a new buyer than a two-year-old restaurant with flat revenues.
In order to help mitigate the risk of future business failure, a potential buyer also may want to see evidence of the following qualities of your business:
- Predictable key drivers of new sales
- Potential for business growth/expansion
- Strong established relationships with suppliers
- A loyal, productive and motivated workforce
- High percentage of repeat sales and customers
- No past or present lawsuits or tax complications
- Established branding with clean trademark, copyright and legal history
- Documented systems and processes for efficient business operations
Even if you are not looking to sell your firm, it is beneficial to understand its value. A precise business valuation will assist you in obtaining investment capital or obtaining a small business loan from your banker.
However, determining the worth of a small firm is not straightforward. There are various techniques for determining the worth of a firm. And whether or not these methodologies are best appropriate for determining the value of your firm is determined by its character.
Therefore, before assessing the value of your business venture, it’s critical to understand how a business appraiser will determine its value. What you need to know is outlined here.
Table of Contents
- Market Method
- Income Method
- Net Asset Method
- Do Not Rely On Numbers Alone
- When Should You Calculate Your Business’s Value?
Market Method
The market technique is one of the most straightforward methods of business valuation for small business owners to adopt and comprehend. Additionally, it avoids the use of numerous theories and calculations.
The market method compares your firm to previously sold enterprises in your industry. These businesses must be comparable in size, revenue, assets, and other qualities to yours. And the valuation of your business will be heavily influenced by the prices investors pay for these enterprises.
Consider the following scenario: you’re selling an auto repair shop. Additionally, local auto repair firms have sold for $250,000. Additionally, you should sell your shop for roughly $250,000 via the market approach.
With the market technique, you can arrive at a valuation near your business’s fair market value. The fair market value of your firm is the price that prospective purchasers are willing to pay for it.
Income Method
This method determines the value of your business by analyzing its financial history. Due to the inadequacy of the income approach for small firms, it is mainly used by large commercial operations. The income method’s objective is to demonstrate that your firm will remain risk-free and lucrative.
When a business valuer employs the income technique, they will examine your organization’s cash flow and profit or loss accounts. They can then forecast your business’s future revenues. And using these estimates may determine the value of your business by discounting future sales to today.
This business valuation approach entails numerous computations that might be perplexing for many business owners. Discounted cash flows, earnings capitalization, and discount rates are only a few of the calculations involved.
Net Asset Method
The net asset technique is recommended for business owners considering ceasing operations or liquidating their assets. This simple strategy requires only a list of your business’s assets and liabilities. And to determine the value of your business, you will subtract the assets from the liabilities.
For instance, suppose your business has $45,000 in assets and $20,000 in liabilities. Your firm is worth $25,000 ($45,000 – $20,000).
Since this is a method of business valuation that disregards your business’s revenues, it is recommended that you avoid using it if you are operating a prosperous business venture.
Do Not Rely On Numbers Alone
The majority of business entrepreneurs forget about this fact. They overlook the reality that other factors can substantially impact the value of their firm. For instance, imagine you believe that the location of your organization has a significant impact on its profitability. In that situation, you should guarantee that your business’s physical location is considered.
When Should You Calculate Your Business’s Value?
The answer to this question is highly dependent on the requirements of your organization. An annual valuation should suffice if your business’s only requirement is information. And you do not need a business appraiser to accomplish this. You can perform the calculations independently.
However, if you require a value to sell your firm, repurchase a portion of your business, or obtain further investment money. You should see a business appraiser for a more precise business appraisal.
Four Common Business Valuation Methods
There are a variety of approaches to arrive at the current estimated value of your business. Below are four common business valuation methods and the pros and cons of each:
1. Book Value (Asset-Based Method) – This method considers your assets and liabilities — the accounting figures recorded on the books. The formula is quite simple: business value equals assets minus liabilities. Your business assets include anything that has value that can be converted to cash, like real estate, equipment or inventory. Liabilities include business debts, like a commercial mortgage or bank loan taken out to purchase capital equipment. If your assets are $100,000, and your liabilities are $30,000, then your business valuation would come out to $70,000.
o Pro: This method may be preferred when others result in giving you a lower business valuation.
o Con: This method may not account for important intangible aspects of your business — such as your long-standing reputation in the community and loyal customer base — which could boost the value of your business in the eyes of potential buyers or investors.
2. Discounted Cash Flow – This method of valuation focuses on the future performance of your business rather than historical data. If your cash flows are consistent and predictable, your business may be more likely to appraise at a higher value. This method estimates the cash flow your business is projected to produce into perpetuity and then discounts this back into current dollars (called net present value or NPV), while also accounting for the level of financial risk indicated by your business or industry. For example, a high-tech software business is usually considered higher risk than a retail shoe store. Our Business Valuation Calculator uses the discounted cash flow method to estimate the value of your business.
- Pro: Many business owners prefer this method of valuation because it focuses exclusively on cash flow, which is often viewed as an influential factor in determining the value of a business.
- Con: This method is based on numerous estimates and projections of cash flow into the future, and if those figures are off base or unrealistic, your business value may be overinflated or underestimated.
3. Revenue/Earnings – This method takes your business’s revenue (gross income) or earnings (net profit after all business expenses are paid) and uses an industry multiplier to come up with a value. If your industry standard multiple is five times sales, and your sales revenue last year was $80,000, then your business would be valued at $400,000 using this method.
An alternate version of this method examines your current earnings, makes projections about your future earnings and uses a multiple to arrive at a business valuation. The measure of earnings can be either EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization).
- Pro: This method offers you a relatively easy and straightforward way to establish a rough estimate of the value of your business.
- Con: Because this method involves making projections about the future revenue or earnings of your business — which may likely fluctuate for a variety of reasons in the coming years — it may lack precision in its estimating approach. For instance, a national recession may create a slump in sales while the closing of a competitor near you could give your business a boost.
4. Market Comparison – A fourth method of evaluation compares businesses in the same market with similar customers that generate revenue close to yours. If you own a small flower shop, for example, you could research other florists within a 10- or 20-mile radius of your location to see what their businesses have sold for in the recent past. Let’s say you found 10 other florists with an average selling price of $55,000. Then you could use $55,000 as a valuation for your business based on market comparison.
- Pro: This method may give you a quick ballpark estimate of the value of your business if sale prices of similar companies are accessible.
- Con: This method may not be as precise as using your assets, cash flow or revenue or earnings because it may be difficult to make exact comparisons with other small businesses that are privately owned. Public information about your competitors may not be readily available.
It would be best if you now understood that there are several methods for determining the value of your firm. Each approach of business appraisal has several advantages and disadvantages. Therefore, carefully assess whether it will produce the most accurate value for your organization before selecting a method.
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