Business Valuation Methods to Know
The accurate valuation of a business is critical to the business-buying process. The value of a business is what a buyer and a seller think a business is worth, based on their own criteria. Most often, a business broker hired by the seller will review the financial records of a business and recommend an asking price. And while our recommendation is to hire a professional to appraise a business, we’ve come up with a few ways to at least get you in the ballpark.
Not only will knowing how to value a business ensure you pay the right price, but you will be seen in the eyes of the seller as someone who knows what they’re talking about.
So how do you calculate the value of a business? There are several ways to make an estimation. We’ll show you the following methods: Discounted Cash-Flow Valuation, Asset Valuation and Market Approach. (One thing to note is that there are different terms for the various methods out there. Just make sure that you and the seller are using the same formula when arriving at a number.)
Discounted Cash-Flow Valuation — Companies usually report their earnings as income before interest, taxes, depreciation and amortization (EBITDA). This number is essential for valuing a company using the discounted cash-flow method. Although this method can be quite subjective, if the buyer and seller both use this valuation method, both parties will be on the same page when they enter the negotiation process. Earnings matter and multiples of earnings are a better way to think about valuation. For example, if the company had a profit of $25,000, you can estimate the earnings over the next few years and then calculate the worth using the long-term Treasury bill interest rate.
Asset Valuation — This is the easiest valuation method, but not always the most accurate for a small business. In asset valuation, you simply calculate what inventory and equipment the business owns as assets and deduct what it has as liabilities. The fault of this method lies in the real value of assets. How do you accurately calculate unique products or services that bring customers back? Exactly. There is likely to be the most contention between the seller and buyer using this method.
Market Approach — The market approach looks at the value of comparable companies that have recently sold or whose value has been made public. It is routinely used by business owners, buyers and professionals to determine a business’ worth, or fair market value. Fair market value is the price that both a buyer is willing to pay and a seller is willing to accept. The key here is to find the most similar competition out there in order for there to be a real apples-to-apples comparison.
While the above methods value the financial side of the business, there are also non-financial considerations that come into play, including competition, supplier price changes and the state of the industry. You should reflect this in your projections for the most accuracy.
And always remember, agreeing on a price point is critical but it shouldn’t be your only deciding factor in buying a business. Most importantly, the business must be right for you in all aspects… not just priced right.