5 Different Ways to Value a Business

Value a Business
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While the exact number varies over time, there are around 33 million small businesses in the US. Many of these businesses are sole proprietorships owned and run by one person. Yet, millions of them are businesses with employees, some with several hundred employees.

When the owners of these employer businesses decide to retire, they can either go through a succession planning process or they can sell the business.

Of course, selling a business requires putting a price on it. Owners often struggle to value a business appropriately because of their personal attachment. If you’re considering selling your business, keep reading for five ways you can value your business.

Reasons for Selling a Business

For many entrepreneurs, the idea of selling their business is anathema. You don’t pour your money and energy into building a business just to sell it off, right?

Yet, more than one business owner does sell when the opportunity presents itself. Why? Let’s look at a few of the key reasons.

It Was Always the Plan

In some industries, selling the business was always the plan. For example, tech startups often aim at building a business up enough that it can attract investors. Then, you build the business up some more.

At a certain point, you start looking around for bigger, better-funded companies to buy you out. Serial entrepreneurs often work this way.

While they love the process of building a company up and making it successful, they get bored with the business once it’s humming along smoothly.

The Failure Rate

Small businesses and startups have an incredibly high failure rate. In fact, around 70 percent of businesses never make it to the 10-year mark.

If you run a business for a few years and someone makes a good offer, that failure rate may incline you to take the offer. It’s a good way to recoup your investment and you get to pass off the business-related debts to someone else.

You Want to Do Something Else

It isn’t just serial entrepreneurs who get bored. A lot of people get to the mid-career point and just walk away to do something entirely different.

Let’s say that you became a general contractor at 25. Now, it’s 20 years down the road. You’ve spent a couple of decades building homes or commercial buildings.

If doing that wasn’t your dream, the option to sell a construction business and start something else may prove too tempting to pass up.

Retirement

For young business owners, selling a company can seem incomprehensible. For a business owner in their late 50s or early 60s, though, the prospect of retirement can look pretty good.

Running a business is demanding at best. As the owner, you probably put in long hours. You’ve spent years making sacrifices, and so has your family.

Retiring lets you spend time with your family, travel, or simply pursue your hobbies.

With some of the main reasons why someone might sell a business covered, let’s dig into some of the main ways that you can value a business going into the business sales process.

1. Book Value

One of the simpler methods of putting a value on a business is calculating its book value. In simplest terms, you add up all of the tangible assets of the business. Then, you add up all of the liabilities of the business.

You subtract the total liabilities from the total assets for a final number. That provides you with the book value.

A different way you can think of book value is to think of it as liquidation value. When you liquidate a company, you essentially sell off its physical assets, such as:

  • Inventory
  • Equipment
  • Real estate
  • Buildings

If, for whatever reason, someone sold off the physical assets of your company, the estimated profit from the sale would represent the book value.

Advantages

One of the key advantages of the book value method is that it’s simple. All you need for this valuation method is the company balance sheet. All of the assets and liabilities should appear there.

While it’s not necessarily easy, it’s relatively straightforward.

Another key advantage of this method is that the person making the valuation doesn’t need to make any assumptions or predictions. They strictly work with the numbers on the page.

Disadvantages

The main disadvantage of this method is that the end result is often quite inaccurate. Clever accounting can often inflate assets and de-emphasize liabilities, or vice versa.

This approach also takes no account of intangible assets. For some businesses, the brand has a value that doesn’t necessarily show up in the books. A business may also own patents or have valuable R&D that isn’t in the books.

While book value is often a convenient shorthand for ballparking a company’s value, its disadvantages make it much less useful as a business valuation method.

2. Discounted Cash Flow

One of the more complicated valuation methods is the discounted cash flow method or DCF. The DCF approach tried to project the value of the business into the future based on cash flows.

In essence, this approach uses current cash flow information to estimate expected future cash flow. However, since it’s notoriously difficult to predict future conditions, the method applies a percentage reduction to those projected cash flows.

If your business operates in a particularly volatile industry, the valuation may apply a steep reduction to future cash flows. Take the construction company mentioned above as a case in point.

Construction is particularly vulnerable to economic conditions. Work typically dries up during slow economic periods or recessions. It booms when the markets pick up.

If you operate in a relatively stable industry, on the other hand, you often face a small reduction. Accounting businesses, by comparison, don’t tend to suffer as much based on economic conditions.

Advantages

The DCF method offers a couple of key advantages in business valuation.

One of the biggest advantages is that it starts from actual data about your business. You can think of it as starting from the intrinsic value that your business holds.

It’s a detailed analysis, rather than a generalized analysis like book value or market capitalization.

Disadvantages

One of the disadvantages is that it’s a data-heavy analysis, which means it’s a somewhat time-intensive analysis.

DCF also depends on predictions. The cash flow reduction percentage tries to offset that problem, but a bad prediction can throw off the numbers a lot.

While DCF has disadvantages, it’s often a far better measure of a company’s value than the alternatives.

3. Market Capitalization

Another relatively straightforward method of business valuation is the market capitalization approach. Rather than focusing on cash flow or assets, this approach focuses purely on stock value.

With this approach, you take all of the stock held by the company’s stockholders and multiply it by the current stock value. So, let’s say that a company has 9.5 million shares outstanding of its available 10 million shares.

While those half a million floating shares have value, they aren’t included in the valuation because no stockholder owns them at the time of the valuation.

So, let’s say that the stock for your business at the close of business today is $12.28. 9.5 million shares x $12.28 = $116,660,000.

Advantages

This approach also has the advantage of simplicity. Rather than spending days or weeks digging into a company’s books, you just look at the shares outstanding and the stock price.

It’s a convenient way of comparing value between companies, at least from an investor’s perspective.

Disadvantages

This approach has several disadvantages. One of the key disadvantages is the volatility of the market. The market may well overvalue a business because the entire industry is in a bubble.

On the flip side, the market may undervalue a business because the entire market takes a hit.

Market capitalization valuation tells you almost nothing about the actual health of the company. A business’s market capitalization may look great, yet, it can have unsustainable debt on its books.

This approach also tells you nothing about the company’s assets, cash flow, or profitability. This approach also has no use as a valuation tool for a privately held business. It only works with publicly-traded businesses.

Market capitalization is also time-constrained. Given how fast and how much stock prices can change, the amount of time between the valuation and the sale can render the valuation all but useless.

Given the limitations of the market valuation approach, it’s not the best option for many small businesses.

4. Times Revenue

The times revenue approach attempts to find an upper limit value for a business. In essence, it looks at your revenue for a set period of time, such as one year. Then, it takes that revenue and applies a multiplier to it.

So, let’s say that your business generated $1.2 million in revenue last year. If the multiplier is two, then you arrive at an upper limit value of $3.6 million. If the multiplier is less than 1, say 0.5, you get an upper limit of $1.8 million.

The multiplier that valuation uses can depend on a lot of factors, such as the industry as a whole, the expected growth of the industry, the projected growth of the specific business, and overall volatility in the industry.

Advantages

The key advantage of this method is that it uses your actual revenue to help determine the potential future revenue of the business. It can also help business owners set practical limits on their expectations of the sale price.

Disadvantages

The key disadvantage of this method is the difference between revenue and profit. It’s entirely possible for a business to bring in a lot of revenue while generating zero profit or even taking a loss.

For example, the supply chain disruptions caused by Covid-19 and other world events drove up the prices of a lot of materials. Those higher prices, in turn, cut into the profits of businesses that rely on those materials.

If a business had thin margins to begin with, a sudden spike in material costs could push the business over the line from profitability to taking a loss.

Poor management in a business can also create a situation where revenues look healthy, but actual profit is nonexistent.

While the times revenue approach has value, it’s best used in tandem with another valuation method.

5. Relative Valuation

Some businesses operate in a way that makes an absolute valuation less than ideal. Companies with very powerful brands or massive public goodwill, for example, derive a lot of value from those brands or goodwill. In other cases, a company works in a particular niche with only a handful of other players on the scene.

In instances like these, a relative valuation can often prove helpful. Rather than look strictly at the numbers or make cash flow projections, the valuation compares the business to similar businesses.

That comparison of similar businesses lets the valuation generate an estimate of the business’s financial worth.

Advantages

One of the advantages of this method is that it makes room for intangibles like brand value. It also puts the business in context with its competitors and peers. You don’t consider the business in a vacuum.

This approach can also loop in factors like the stock price.

Disadvantages

One of the key disadvantages of relative valuation is the opportunity for subjectivity and bias. The final value assigned may fluctuate wildly depending on the businesses chosen for comparison.

While relative valuation is a common approach, it’s not necessarily the best or most accurate approach by itself.

Picking a Way to Value a Business

For business owners looking to get out, picking a way to value a business is often challenging. Every approach has meaningful disadvantages that can potentially throw off the valuation.

In practice, employing two or even three valuation methods is often the best approach. For example, you might pair a discounted cash flow valuation with a relative valuation. Getting multiple valuations helps provide a more realistic sense of what the business is actually worth.

Looking for more business finance information? Check out our Business section for more posts.