Business Valuation

Some 12 million businesses will sell in the next decade, many of them small businesses owners who are not fully equipped to set an appropriate dollar value for their businesses. I witnessed this firsthand when I attended a conference and 80% of the crowd of small business owners were unable to estimate the enterprise value of their businesses. Understanding business valuation is important even if you aren’t selling your businesses – as valuations may be used for establishing partnerships, taxation, estate planning or succession planning.

I have valued hundreds of businesses and completed over 50 mergers and acquisitions, mostly where I represented the buyer, so have come to learn how those who set a business’ value practice their craft.

Sales price will ultimately be determined when a buyer and seller agree on price and terms of a sale. The better you understand what factors drive value of a company, the better you can make an informed decision as seller. These factors drive the essence of value:

Free cash flow: is at the heart of most company valuation calculations. It is how much cash you have left after paying for operating the company and any capital expenses. Capital are the assets (think equipment) you need to run your company. If you manufacture things you need many assets; if you are a service company, perhaps it is your vehicle, or office; if you are a tech entrepreneur, perhaps your only asset is a laptop. The larger your free cash flow, the more the company is worth.

Variability: often the less variable your cash flow is, the higher your value. If you are entering a new market, or new geographic area, one would expect greater variability in certainty of demand or earnings. If you have a stable workforce, your company’s value is likely higher than one whose employees have 100% or greater turnover.

Potential: think of this as opportunity to expand. Are your sales or prospects limited to a season of the year, or tied to a geographic area? If so, so is your potential to grow profits. If you have a recurring revenue model (like a national membership company) then your potential is greater than a ‘one-and-done‘ business (like a regional fence company)

Opportunity Cost: captures the idea that there are other alternatives for your investment. If savings rates at a bank are higher, then a reasonable person would need a higher return on their investment to invest or buy your business

EBITDA: Earnings Before Interest Depreciation and Amortization is a measure of core company profitability and calculated by adding interest, tax, depreciation and amortization to net income. It is helpful measure of core profitability as it factors out how a company is financed (interest), its legal entity (taxes) or its accounting rules to spread the cost of assets over time (depreciation and amortization)

Once you know the variables that determine a business value, the next step is calculating value. There are several common ways to calculate value, and I list the most common here. As we look at these different valuation methods, we will use an example of a small business that builds fences. Let’s assume Fence Co. has $750k in annual revenue, and annual EBITDA of $100k.

Comparative Multiples (or Comps): Looking at comparable sales are a helpful peg of value. Like a report of home prices in your neighborhood is a good way to determine the ‘market’ price per sq foot of your home, comps (either revenue or EBITDA) in business are a helpful yardstick to determine value of your business.

Multiple of Revenue: is a simple model that values a business at a multiple of its annual revenue. All revenue isn’t created equally, so these vary widely by industry. A low margin business like a grocery store may trade at 0.5X revenue, while a tech company can sell for >40x revenue. Let’s assume that most companies in the fence industry (the comps) sell for 1.0x revenue. Your company value would be $750k x 1.0 = $750k

Multiple of EBITDA: is a simple modeling tool that multiplies the EBITDA of the most recent year (or TTM – training twelve months). For example, most small businesses are valued between 3x – 5x EBITDA. This varies by industry, size of company, growth of revenue, assets needed, employee turnover, and many other factors, but is an good approximation of value and the most often used in my experience. I our example, annual EBITDA is $100k, and we multiple this by our EBITDA multiple. $100k x 5x EBITDA = $500k company value.

Simple Valuation: A close approximation of value is dividing your annual free cash flow by a hurdle rate. In our example lets assume we have annual cash flow of $100k, and our hurdle rate is 12%, then a value that approximates is $100k/12% = $833k.
DCF: The discounted cash flow method is a more complicated method used by finance professionals. But, I do think understanding the basics will help business owners understand this common valuation method.

DCF uses a forecast of future free cash flows and discounts it back to today, resulting in a company value (or Net Present Value). From this you would add cash on hand and subtract any debt to determine the value of the business.

The first step is to (1) forecast future cash the company will generate, by year. You can extrapolate the past into the future, and project a realistic growth of revenue and expenses.

Money today is worth more than money in the future because money in the present can be invested and thereby earn more money. So – we then (2) need to value those future cash flows. To do that we do some math, using a ‘hurdle rate’ – or % return (called WACC – weighted average cost of capital) you would be willing to take tomorrow in exchange for what you have today. This is a company’s opportunity cost, meaning if you can’t find a higher rate of return elsewhere, you should keep or invest in your own business.

Finally (3) you add in cash and subtract debt to the NPV value to determine the enterprise value of your company. I provide a link here to a simple DCF model that has the formulas imbedded. Simple DCF Model

As you can see above, each of these approaches results in a slightly different result ranging from $500k to $833k. Valuation is a science but also an art – there is no one way to value a company, so acquirers often use several different models to triangulate on a value.

I hope these ideas help you understand the company value drivers as well as the common ways experts place a number of a business’ worth.

If you are thinking of selling your business, I suggest:

Get your financial statements in order, so you know true profitability and cash flow of your company
Study sales of similar businesses, and what drives their value and sales comps
Know your motivations and what you are walking away to, to ensure it is better than your current state
Engage experts who can help you model and value your business, and negotiate with the buyer wisely