Table of Contents
- Key Processes in Valuing Your Small Business
- Assets Based Method
- Ratio-Based Method
- Seller’s Discretionary Earnings (SDE) Method
- Market Comparison
- Discounted Cash Flow Method
- Organize Your Finances
No matter what leg of the business journey you’re currently on, it’s important to know how to value a business. There are lots of reasons you’ll want to understand how to do this: for purposes of buying or selling, attracting investors, buying out other owners, applying for a loan, tax purposes, or simply to better understand your business’s growth. (1)
In this article we’ll take a look at the different approaches you can take to value your business, explain in detail how each one works, and share which types of business benefit from each method.
Key Processes in Valuing Your Small Business
There are a handful of ways to value a business. Each will have its own benefits and risks, and some of these may depend on specific circumstances. We’ll take a look at each type and you can decide which of these methods will work best for your company.
Assets Based Method
A fairly common way to go about small business valuation is to do it on an assets-based approach. This means summing up the company’s total assets–property, inventory, equipment, plus intangibles like brand, copyrights, and customer base, and its liabilities–payables and expenses. Then find the difference between these two numbers.
If your books are pretty well in order, this method is pretty simple, and should reflect the numbers already on your balance sheets. Simply add all of your assets, and subtract your liabilities. To get the most accurate picture, take some time to adjust equipment, property, or inventory to current fair market value.
This is a good method for internal use, for budgeting purposes (2), but it is also widely used for companies that are liquidating, aren’t profitable, or are mainly for holding real estate or investments.
A price-earnings (or P/E) ratio is the value of a company divided by it’s after-tax profits.
The equation for this is:
Value = Earnings after Tax x P/E ratio.
If using a P/E ratio, you’ll have to find the right one to use…one that is acceptable to a buyer, seller, or investor. There are several to choose from, and an accountant or business broker can let you know whether there is an industry average or standard you can use. You can also consult an industry association, financial publication, or Chamber of Commerce for guidelines.
Seller’s Discretionary Earnings (SDE) Method
The SDE method is one that is used solely for small business, and is helpful for those who are looking for how to value a business for sale. This is because SDE will help determine what yearly income may be expected from the company in question.
Begin by calculating the business’s earnings before interest and taxes (EBIT). Next, add back the owner’s compensation, and employee benefits (i.e. health insurance, life insurance, 401k, disability, professional development, etc.). Finally, include non-recurring and non-essential expenses such as consulting fees or travel.
If you are the seller in this scenario, be ready for some pushback from the buyer. There will likely be some debate over certain numbers, and an agreement must be reached before the sale can close.
This method of valuing a company determines value from examining other comparable companies within the industry. All kinds of businesses use this approach, although it can be extra helpful for businesses that are growing fast or are a part of a rapidly growing industry.
It requires a good deal of detailed data collection so that the comparison is accurate. However, if possible, market comparison is a great way to find a reasonable buying or selling price that is inline with the local market.
Discounted Cash Flow Method
Discounted cash flow method is a good choice for newer businesses that aren’t profitable yet, but have a high-growth potential. This is a forecasting approach that adjusts the company’s cash flow to reflect the risk of purchase.
Organize Your Finances
Before attempting any of the methods for valuing a company, you’ll need to get your financial house in order. If you haven’t already, take stock of all your assets. These include the following:
- Real estate, property
- Means of production or equipment
- Intangible assets (patents, trademarks, reputation, brand, subscriber base, intellectual property, etc.)
You will then need to compare these assets against your liabilities. These include:
- Any business loans
- Accounts payable
- Notes payable
- Any other debts or payables (this includes unearned revenue)
Make sure that you have a strong business plan and model in place. If you are looking for investors or trying to sell, you’ll need to demonstrate just how your company turns a profit. Even if you’re are the buyer, you want to know exactly what you’re getting into, and how your potential business will make money, as well as how it plans to grow.
How do you determine the value of a small business?
As we outlined in this article, there are several ways to value a small business. If you want a truly accurate estimate, you’ll want to work across several of these methods.
How do you value a business quickly?
When looking for how to value a business for sale quickly, the best way is to have it done by a professional, using an appraisal service. If you want to do it yourself and your finances are in good order, you can work quickly using an assets based measure.
What is the rule of thumb for valuing a business?
Generally, you’ll want to take a compare and contrast approach. Choose 3 or 4 of the valuation methods to get a good idea of what the numbers are saying. If they’re fairly close, you can get an average that should make sense.
How many times revenue is a business worth?
On a national level, the average business sells for about 0.6 times the annual revenue.
How do you calculate what a business is worth?
There are different approaches you can take, but all of these approaches are dependent upon having your finances in good order. Know your total assets and liabilities, and what P/E ratio to use. Evaluate every aspect of your assets at current fair market value (including equipment or means of production, real estate, etc.)
How much is my business worth if I sell it?
This depends on many factors. You’ll need to look at the hard numbers, like assets and liabilities. But yo’ll also have to take into account any relationships you have with suppliers, brand recognition, patents, or intellectual property.