How Are Businesses Valued? Here’s What Every Owner Needs to Know
Knowing your business’s value is crucial to reaching your goals, whether you plan to grow your business, sell it, and/or retire from it. Integral to knowing your business’s value is understanding how businesses are valued and the factors that impact, that all-important metric, your organization’s value.
In this article, we’ll go over what a business valuation is, the main value calculation methods, the key factors that determine your business’s worth, and how your business valuation relates to different business goals.
What Is a Business Valuation?
A business valuation is the process of determining the economic value of a company or business unit. Simply put, it’s a way to assess what a business is worth.
How Are Businesses Valued?
Understanding the various business valuation methods available is essential for calculating your business’s worth and planning for the future.
Multiple Method is the Most Common
Most small businesses worth under $50 million are usually valued by the multiple method.
What the Multiple Method Is: In the multiple method, your business is valued based on a multiple of key metrics like revenue, gross profit, or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Why It Matters: The multiple method is the go-to for over 70% of buyers and sellers when determining a business’s value. Other approaches are discussed below, but the multiple method is the most critical valuation technique to understand because it is so popular.
Future Income Method: The Future Has Value
There are two main ways to value your business based on its future potential:
Discounted Cash Flow (DCF) Analysis: This method estimates the present value of future cash flows your business is expected to generate.
Capitalization of Earnings: In this approach, your business’s expected future earnings are divided by a capitalization rate, which is the rate of return a company generates relative to its total value. The formula for this being Net Operating Income (EBITDA) divided by Equity or Current Market Value.
Market Method: Comparing Your Business to Others
Valuing your business by comparing it to similar companies in your industry can offer insights into its worth:
Comparable Company Analysis (CCA): By comparing your business’s financial ratios with those of similar companies, you can better understand its potential value.
Recent Similar Transactions: This method looks at what businesses like yours have recently sold for. Just like taking a look at “comps” when buying real estate.
Asset-Based Method: Unlocking Value from What You Own
An asset-based approach can help you understand the tangible value your business holds:
Book Value Method: Here, your business’s value is estimated based on subtracting liabilities from assets on your balance sheet. The more assets your business holds, the more value it has.
Adjusted Net Asset Method: This approach adjusts the value of your business’s assets and liabilities to reflect their market values rather than their book values.
What Are the Key Valuation Factors?
Many factors, both tangible and intangible, drive your business’s value, and understanding them is crucial for knowing how your company measures up in the market.
Tangible Factors
Tangible factors, such as financial metrics and operational capabilities, directly impact your business’s economic worth. These are largely considered in business valuation methods and calculations.
Cash Flow: Cash flow measures how much cash your business takes in versus how much cash goes out.
Profitability: Profitability indicates how much your business makes after accounting for operating costs.
Growth: Growth can be measured not just in revenue but also in expanding operations and market reach.
Scalability: A scalable business increases its profit margins as it grows.
Intangible Factors
Beyond financials, intangible elements like your ownership style significantly influence the long-term value of your business. While these are not directly connected to the calculations used to generate your business value, they impact how those looking at your business perceive its value.
Operations: Standard operating procedures (SOPs), which are detailed instructions for completing tasks, maintain operational consistency. If your business has SOPs, then even with leadership (or any personnel) changes, there will be a high confidence that operational consistency can be maintained. Furthermore, businesses with SOPs are able to scale more effectively.
Ownership Style: Building a self-sustaining company that doesn’t rely heavily on your involvement will command a higher valuation. Whereas a business dependent on one individual, especially if the person is leaving, can be seen as risky, lowering the business’s value.
Fundability: Fundability isn’t just about securing investors; it’s also about whether your business can obtain financing to fund growth. A company that demonstrates sound financials and scalability is more likely to attract lenders and investors, which will enhance its long-term value.
Employee Turnover: Businesses are powered by the people in them. This is why a business valuation can be directly influenced by its rate of employee turnover. Low employee turnover is associated with not only high morale but also business stability. On the other hand, high turnover rates can signal underlying issues that can negatively impact the business’s reputation and financial standing.
Brand: The signs of a strong brand are a good reputation, low customer churn rate, and high brand awareness. Strong brands are worth more because not only do they have a loyal client base, but their strong reputation and strength in the marketplace make growth and scaling easier.
The Bottom Line
Regardless of your goals as a business owner, knowing your business’s valuation is important. Here are a few popular goals and how understanding and keeping track of your business valuation is helpful.
If You’re Looking to Sell: Just like anything else, knowing what something can sell for is crucial. However, when selling a business, understanding your business’s valuation also lets you know where there are opportunities to increase your valuation and strengthen your negotiating position—provided that you leave enough time to take advantage of those opportunities.
If You’re Planning for Retirement: As a business owner, retirement and retirement planning looks a little bit different. In fact, if you’re looking to retire, you may be looking to sell your company or pass it on to a family member. In either case, your business should be considered an asset in your portfolio, hopefully, one of the most valuable assets on your personal financial statement. Like any other portfolio asset, its value should be known, tracked, and incorporated into your retirement planning.
If You’re Seeking Funding: Similar to selling, whether you are looking for a loan or an investment, you’ll need to know the value of what you have to understand what you can ask for. Lenders want to know that your business can generate enough revenue to cover loan payments, and investors want to know that they will see a healthy return. Knowing your business valuation helps you understand your funding options and next steps.
If You’re Looking to Grow: Even if you aren’t looking for funding to fuel business growth, knowing and tracking your business valuation is essential. Think of your business valuation as a barometer of business health. Your business valuation indicates your business’s financial health and standing in the marketplace. Understanding and knowing this information can help you decide what to do next.
Getting Started
It’s best to speak with a knowledgeable merger and acquisition advisor to get a complete business valuation and informed insights on how it can support your business goals. Have questions about your business’s value and goals? Our team of merger and acquisition advisory experts is here to help. Contact Us.