Business valuation is a process that follows a number of key steps starting with the definition of the task at hand and leading to the business value conclusion. The five steps are:
Let’s examine in more detail what happens at each step.
Step 1: Planning and preparation
Just as running a successful business takes planning and disciplined effort, effective business valuation requires organization and attention to detail. The two key starting points toward establishing your business worth are:
- determining why you need business valuation
- assembling all the required information
It may seem surprising at first that the valuation results are influenced by your need for business valuation. Isn’t business value absolute? Not really. Business valuation is a process of measuring business worth. And this process depends on two key elements: how you measure business value and under what circumstances.
In formal terms, these elements are known as the standard of value and the premise of value.
Business value depends on how and why it’s measured
A few examples will illustrate this important point.
Let’s say you want to sell your business. Business has been good, with revenues and profits growing each year. You plan to market the business until a suitable buyer is found. You want to pick the best offer and are not in a hurry to sell.
In this situation your standard of value is the so-called fair market value. Your premise of value is a business sale of 100% ownership interest, on a going concern basis. In other words, you plan to sell your business to the highest and most suited bidder and it will continue running under the new ownership.
Next let’s imagine that you own a small business that has developed a product of great interest to a large public corporation. They already approached you offering to buy you out. They have some great plans for your product and want to sell it internationally. These people are even prepared to offer you some of their publicly traded stock. As your CPA tells you this can significantly lower your taxable gain on the business sale.
In this scenario you have a synergistic buyer who is applying the so-called investment standard of measuring your business value. Such buyers are often willing to pay a premium for a business because they can realize some unique advantages through a business purchase.
Now consider a situation where the business owners need to settle a large bill with one of the business’ creditors who is tired of waiting. There is not enough cash in the bank to cover the amount, so business assets need to be sold quickly.
This is the case where the so-called forced liquidation premise of value may apply – business owners don’t have enough time to look for a suitable buyer and may have to resort to a quick auction sale.
Once you know how and under what conditions you will measure your business worth. it is time to gather the relevant data that impacts the business value. This data may include the business financial statements, operational procedures, marketing and business plans, customer and vendor information, and staff records.
Business facts affect business value
Here are a few examples of how information about the quality of operation affects the business value.
Well-documented financial statements and tax returns are essential to demonstrate the business earning power.
Steady, above industry norm earnings tend to translate into higher business value.
Detailed written business operating procedures make it easy to understand how the business works, who does what, and what skills are required.
Since it is easier to take over a well-organized business, there is higher business buyer interest and competition among them tends to increase the business selling price.
A good marketing plan provides the essential inputs into the future business earnings projections. And accurate earnings projections are key to establishing the business value based on its income.
A look at the customer list quickly shows where the business gets its revenues. Businesses that do not rely on a few large customers for most of their business sales tend to command a higher selling price.
Let’s say that the business enjoys an exclusive distribution agreement with a major vendor, a key competitive advantage. If this agreement can be transferred to the business buyer, the business selling price is likely to be higher.
Skilled and motivated staff is essential to business success. Not surprisingly, if experienced long-term employees stay with the business after the sale, the selling price is likely to reflect it.
Some of the information will provide immediate and useful parameters to determine the business value. Other parts of this data, notably the company’s historical financial statements, require adjustments to prepare inputs for the business valuation methods. We discuss the financial statements adjustment process in the following sections.
Step 2: Adjusting the historical financial statements
Business valuation is largely an economic analysis exercise. Not surprisingly, the company financial information provides key inputs into the process. The two main financial statements you need for business valuation are the income statement and the balance sheet. To do a proper job of valuing a small business, you should have 3–5 years of historic income statements and balance sheets available.
Many small business owners manage their businesses to reduce taxable income. Yet when it comes to valuing the business, an accurate demonstration of the full business earning potential is essential.
Since business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company historical financial statements may need to be recast or adjusted.
The idea is to construct an accurate relationship between the required business assets. expenses and the levels of business income these assets are capable of producing. In general, both the balance sheet and
the income statement require recasting in order to generate inputs for use in business valuation. Here are the most common adjustments:
Step 3: Choosing the business valuation methods
Once your data is prepared, it is time to choose the business valuation procedures. Since there are a number of well-established methods to determine business value, it is a good idea to use several of them to cross-check your results.
All known business valuation methods fall under one or more of these fundamental approaches:
Tools to Value a Business
The set of methods you choose to determine your business value depends upon a number of factors. Here are some key points to consider:
- The complexity and value of the company’s asset base.
- Availability of the comparative business sale data from the market.
- Business earnings history.
- Availability of reliable business earnings projections into the future.
- Availability of data on the business cost of capital. both debt and equity.
Choosing the asset based business valuation methods
Determining the value of an asset-rich company may justify the cost and complexity of the asset-based valuation methods, such as the asset accumulation method. In addition to valuing the individual business assets and liabilities, the method can be helpful when allocating the business purchase price across the individual business assets, as part of the asset purchase agreement.
However, the method requires considerable skill in individual asset and liability valuation which often makes its application costly and time consuming.
Business Value = Assets + Business Goodwill
How the market based business valuation methods work
Market based business valuation methods focus on estimating business value by examining the business sale transaction data available from the actual market place. There are two types of transaction data that can be used:
- Guideline transactions involving similar public companies.
- Comparative transactions involving private companies that closely resemble the subject business.
The advantage of using the public guideline company data is that it is plentiful and readily available. However, you need to be careful when selecting such data to make an “apples to apples” comparison to a private company.
In contrast, reviewing business sales of similar private companies provides an excellent and direct way to estimate the business value. The challenge is gathering sufficient data for a meaningful comparison.
Regardless of which market-based method you choose, the calculations rely on a set of so-called pricing multiples that let you estimate the business worth in comparison to some measure of the business economic performance. Typical pricing multiples used in small business valuation include:
Each pricing multiple is a ratio of the likely business selling price divided by the respective economic performance value. So, for instance, the selling price to revenue multiple is calculated by dividing the business selling price by business revenue.
To estimate your business value, you can use one or more of these pricing multiples. For example, take the selling price to revenue pricing multiple and multiply it by the business annual revenue. The result is the business selling price estimate.
Valuation multiple formulas
More sophisticated market based business valuation methods, such as the Market Comps in ValuAdder, use business pricing rules that make an intelligent choice of which pricing multiplies to apply when valuing a business. In addition, the Market Comps let you account for key business attributes automatically:
Valuing a Business based on Market Comps
The income based business valuation
Income based business valuation methods determine business worth based on the business earning power. Business valuation experts widely consider these methods to be the most accurate. All income-based business valuation methods rely on either discounting or capitalization of some measure of business earnings.
The discounting methods, such as the ValuAdder Discounted Cash Flow. produce very accurate results by letting you specify the details of the expected business income stream over time. The Discounted Cash Flow method is an excellent choice for valuing a young or rapidly growing company whose earnings vary considerably.
Alternatively, the so-called direct capitalization methods, such as the ValuAdder Multiple of Discretionary Earnings. determine your business worth based on the business earnings and a carefully constructed capitalization rate. The Multiple of Discretionary Earnings method is an outstanding choice for valuing small established companies with consistent earnings and growth rates.
How to Value a Business as Multiple of Earnings
Step 4: Number crunching: applying the selected business valuation methods
With the relevant data assembled and your choices of the business valuation methods made, calculating your business value should produce accurate and easily justifiable results.
One reason to use several business valuation methods is to cross-check your assumptions. For example, if one business valuation method produces surprisingly different results, you could review the inputs and consider if anything has been overlooked.
ValuAdder business valuation software helps you focus on the big picture of determining the business value by automating complex calculations and letting you easily adjust and capture your assumptions while running multiple what-if valuation scenarios.
Step 5: Reaching the business value conclusion
Finally, with the results from the selected valuation methods available, you can make the decision of what the business is worth. This is called the business value synthesis. Since no one valuation method provides the definitive answer, you may decide to use several results from the various methods to form your opinion of what the business is worth.
Since the various business valuation methods you have chosen may produce somewhat different results, concluding the business value requires that these differences be reconciled.
Business valuation experts generally use a weighting scheme to derive the business value conclusion. The weights assigned to the results of the business valuation methods serve to rank their relative importance in reaching the business value estimate.
Here is an example of using such a weighting scheme: