Plan on selling your business and want to know what your business is worth? There is no where else on the internet where you will find a more detailed business valuation information than right here.
This article shows you how professionals like Evaluate Advisory derive business worth through fundamental calculations.
After this article, you will be able to:
- Know the earnings type used in small business sales and how to calculate it.
- Understand the valuation methods and concepts for small business valuations.
- Understand the pros and cons of each valuation methods.
What is Business Valuation Really About?
I often hear business owners ask me, what do I think their business is worth? 2x earnings? 3x? They think in multiples but they do not realize:
multiples we use is derived from behind the scene (fundamental) calculations.
We are experts on how to value a small business using 3 approaches: Income, Market and Asset Approaches. Across these 3 different approaches are over 8 different valuation methods that I will go into more detail below.
With some good fundamentals and data, you should be able to come up with a ballpark of what your business is worth. The only uncertainty is whether you did it right. Many business owners who are selling their business get professional valuations for this assurance. Sure it costs money, but is saving $2,500 worth the risk of undervaluing your business by $20,000 or more?
3 Steps to value a small business:
Step 1 – Normalize your earnings.
Step 2 – Calculate Enterprise Value using as many valuation methods as relevant.
Step 3 – Find the average Enterprise Value of all methods used.
STEP 1 - NORMALIZE YOUR EARNINGS
Normalization to get Seller’s Discretionary Earnings
We need an important earnings figure from your income statement prior to calculations using valuation models. We use a derived earnings figure called Seller Discretionary Earnings (SDE) or Seller Discretionary Cash Flow (SDCF).
No wall of words here. These are the steps and formulas:
SDE = Pre-tax Income + Discretionary Expenses + Non-cash expenses + One time expenses + One working owner wage
* illustration below does not include every possible variation of discretionary expenses. To make sure you capture everything, contact us.
How to calculate SDE (figures for illustration only):
|+ One owner wages||$80,000|
|+ other salary and adjustments||$25,000|
|+ Family and personal insurance||$12,000|
|+ Personal vehicle||$6,000|
|+ Personal vehicle expenses||$3,500|
|+ Interest expense||$500|
|+ other discretionary items||$15,000|
|Seller Discretionary Earnings – SDE||$167,000|
Now that you know the most important figure on how to value a small business, you are ready to learn valuation methods to determine what your business is really worth.
STEP 2 - CALCULATE ENTERPRISE VALUE
A. Income Approach
1. Discounted Cash Flow (DCF) Valuation Method
If you wanted a method on how to value a small business that produces a multiple instead of just making adjustments to a multiple, it would be the DCF valuation method. Using DCF requires good finance knowledge as it can get complex.
The discounted cash flow valuation model is a frequently used in finance to determine the value of a business as a going concern.
The gist of this model is ‘to determine today’s value of all projected future cash flow of a company adjusted for risk’.
If that sounds gibberish, just imagine the reverse of earning interest from a bank. The bank pays you interest for your deposits over time. In DCF, you are trying to find what all that future interest is worth TODAY.
The cash flow we use for small business valuations is different than for a large corporation like Apple. It is a simplified model without taking into account cash flow to firm and cash flow to equity.
When calculating the DCF for a business, the cash flow we use is either the SDE (Seller’s Discretionary Earnings), or EBITDA (Earnings Before Interest Taxes Depreciation and Amortization).
In a general rule of thumb, owner operated businesses earning below $500,000 a year will use SDE. Owner absent (or minimally involved) businesses earnings over $500,000 will use EBITDA for the calculations.
Steps to using Discounted Cash Flow:
- Determine the Cash Flow (SDE or EBITDA) for each of the previous 3 years.
- Give a weight to each year totaling 100%.
- Determine the right Discount Rate for the company (Rule of Thumb 30-35% for SDE and 20-25% for EBITDA. Or use CAPM-Capital Asset Pricing Model to derive from scratch)
- Using this weighted average SDE/EBITDA, project earnings over the next 5 years.
- Use the Discount Rate to find the Present Value of the projected Cash Flows for the next 5 years.
- Add up all the PV to give you Net Present Value (NPV)
- Find the capitalization rate and steady growth rate to calculate the Terminal Value.
- Add the Terminal Value and the NPV of Cash flow Year 1 – 5.
- The total becomes your Enterprise Value using the DCF method.
2. Capitalization of Earnings Valuation Method
The Capitalization of Earnings method is a basic and simplified version of in the Income Approach method.
The first step is to to determine the capitalization (cap) rate which is simply the discount rate minus the growth rate. Once the capitalization rate is determined, you divide the earnings by the cap rate to give an estimate of enterprise value.
This Income Approach model assumes that the future growth rate remains steady into perpetuity. It may be used with relatively accurate results on mature businesses with steadily growing earnings.
Steps to using Capitalization of Earnings:
- Determine the discount rate with CAPM, rule of thumb, or market data.
- Find out the growth rate for your industry by region, countrywide, or global. The more localized, the better.
- Calculate the capitalization rate (discount rate – growth rate = capitalization rate)
- Know which earnings to use (EBITDA or SDE).
- Determine the value of the earnings figure to use. Best approach is weighted average of min 3 years earnings.
- Adjust price for lack of marketability if the discount rate was derived from publicly listed corporations.
- Determine the Enterprise Value.
3. Discretionary Earnings Multiple Valuation Method
The Discretionary Earnings Multiple method involves creating a table of factors affecting value, then assigning each factor with a multiple and the weightage in order to get weighted average multiple.
This is the method that many business brokers with little finance knowledge would use because of its simplicity. When business owners want to know how to value a small business, they will frequently refer to this earnings multiple.
The only issue with this valuation method is that it is subjective, may not be uniform among all users, and it requires presumption for a starting multiple. The multiple, weights, and even the factor itself is subjective (the valuator decides on the starting multiples) but can be defended by the appraiser. Therefore, using this method may result in values that differ from appraiser to appraiser.
Once a weighted average multiple is determined, it is multiplied by the SDE or EBITDA of the company to get an Enterprise Value.
Steps to using Discretionary Earnings Multiple:
- Identify factors that affect value and assign minimum of 3 levels and match each level to a multiple.
- Give appropriate weight to each factor according to level of impact on business value.
- Multiply the selected factor multiple by the assigned weight and add them all up.
- Multiply the weighted average multiple by the (weighted) average discretionary earnings.
- Final value is the estimated enterprise value
B. Market Approach
1. SME Transaction Comparables Valuation Method
The first Market Approach to business valuation is by using SME transaction comparable data. This is a great way on how to value a small business because you do not rely on theoretical or opinions. The past business sale transaction data is concrete. This obtainable data is through voluntary submission by business brokers into several databases. This data is then resold through several database vendors for a fee typically in the hundreds of dollars.
Using past transaction data of SME business sales, we can have a strong feel for the value of a current comparable business. The market data used in this method shows what the market is willing to pay for a similar business. Therefore, the information obtained from this approach is not theoretical, but direct from the market.
The market is made up of thousands of buyer and sellers. To understand the market, we need to know what buyers’ objectives are. The two factors affecting their decision are what the earnings are, and what they are willing to pay for that earnings.
Steps to using SME Transaction Comparables:
- Get transaction data for comparable businesses with data purchased from good sources.
- Review the data, study the dates and adjust for market conditions and outliers.
- Compile values.
- Adjust target company multiples of your business to comparable data to account for revenue size, efficiencies, profitability. i.e. if your business has a higher gross margin than the comparables, increase your multiple by a factor. If your inventory turnover is lower than comparables, decrease your multiple by a factor.
- Average the earnings multiple (SDE or EBITDA) of given data.
- The average multiple multiplied by your business SDE or EBITDA will give you an estimate of the enterprise value of your business.
2. Public Company Comparable Valuation Method
The second method in the Market Approach for business valuation is the Public Company Comparable method. Due to SEC or Provincial Securities Commissions in Canada requiring audited financial statements and disclosure of public companies, data on such companies are freely available to anyone. This allows anyone to use these data to compare other similar companies.
While this is not the preferred method when we want to know how to value a small business, it is useful when there is no transaction data available for a similar business. We can take the public company data and make adjustments to it to get it ready as a comparable.
Generally, the Public Company Comparable method may be used to evaluate a business valued over $50 million using 3 or more similar public companies but can be used for smaller businesses after very sophisticated tweaks and adjustments.
Steps to using Public Company Comparable
- Find the SIC Code and/or ask the business owner who they compete with that are public(listed) companies.
- Identify 3 or more similar companies.
- Extract the current financials for the public company and the current stock price and performance. PE ratio. Discard low liquidity companies (low traded volume or penny stocks/pink sheets).
- Discard companies with unusual activity. i.e. acquisition target announcements (inflated stock price), share buyback announcements, etc.
- Calculate the private company financial ratios and compare with the public company ratios. Make adjustments accordingly.
- Make adjustments to private company for lack of marketability, better key financial ratios, etc.
- Use the average multiple (or PE ratio) to calculate the value of the private enterprise adjusted for lack of marketability.
3. Merger & Acquisition Comparables Valuation Method
The last but equally important Market Approach method is the M&A Comparable method. The M&A Comparable method and the Public Company Comparison method are similar within the Market Approach but with subtle differences. Instead of taking data from the stock market, it is taken from M&A deals where the information is better available than for SME transactions.
Steps to using Merger & Acquisition Comparables
- Search for a few sample M&A transactions for similar companies.
- Compile data, analyze, compare, and adjust to subject (company you are valuing) for size, financial ratios, lack of marketability (if any).
- Use the average multiples of comparables to determine subject company value.
C. Asset Approach
1. Capitalized Excess Earnings Valuation Method
When most business owners think about how to value a small business, they rarely consider an asset approach. Unless of course they were facing bankruptcy and liquidation. The asset approach, while not my first choice, does offer an alternative valuation method when the first two requires additional confirmation.
The first method to the Asset Approach is the Capitalized Excess Earnings method. You calculate the value of the business by first finding the fair market value (FMV) of the net tangible assets, then by finding the value of the goodwill (excess earnings). The total of these two combined gives the value of the enterprise.
Steps to Capitalized Excess Earnings
- Determine the FMV of tangible assets.
- Determine the business earnings.
- Calculate the weighted average cost of capital (WACC) with either CAPM
2. Asset Accumulation Valuation Method
The second Asset Approach is the Asset Accumulation method. This is most useful when the value of the assets is greater than the capitalized value of the company. Meaning the value of the parts is greater than the whole.
So when you use this method, you are not in essence asking how to value a small business but rather how to value your assets in a small business. This often occurs in capital intensive businesses where the earnings are insufficient to generate sufficient goodwill.
This valuation method is used for companies when earnings are inadequate to give a value greater than the FMV of assets.
Steps to using Asset Accumulation
- Determine tangible assets FMV.
- Also find all intangible assets FMV including off balance sheet assets.
- Look for any off balance sheet liabilities.
- Add all the assets minus the liabilities.
- Final amount is the value of the business.
Frequently Asked Questions about Business Valuation
Will I be able to value my small business on my own accurately?
The simple answer, maybe. The technical answer, no you probably will not.
Assuming you have no finance knowledge (PV, NPV, DCF, Perpetuity formulas, Discount Rate, Nominal vs Real rates, Risk Free rate, etc), it would be difficult to do a valuation on your own to the satisfaction that you know you are not coming short in price or in most cases, having an overly optimistic estimation.
If you are not an expert on income statement normalizations, you may be missing out on 10, 20, even 50 thousand or more in Enterprise Value.
On the flip side, if you massaged the numbers and gave yourself a loose discount rate estimate, you might end up with a valuation that is too high and result in little or no inquiries. Buyers are very well income these days.
What is normalization of income statement?
The simplest explanation of normalization is to determine the total amount of earnings available to any buyer regardless of:
- Personal tax optimization strategies (personal expenses, insurance, auto, etc)
- Depreciation/amortization. These are non-cash expenses, meaning they appear as expenses but you probably did not actually pay for them that year.
- How much an owner decides to pay themselves.
- Other discretionary items.
Is there a simpler way on how to value a small business?
Many people with non-finance background often talk about multiples. This is easy to understand as you take earnings and simply multiply it to get a business value. Different industries will have different multiples and businesses with higher SDE/EBITDA typically get a higher multiple.
You may estimate that you could sell for 2-3 times earnings but in order to know if your business could get 2.7x earnings will require a more in depth look at every financial and business aspect of the company.
Enterprise Value is so much more than just slapping on a multiple and even coming short of $5,000 in value is worth a professional valuation by itself.
How comprehensive must my business valuation need to be?
Certified valuations usually cost a minimum of $10,000-15,000 and will give you 50 pages of very detailed work. People use them in divorce or partnership dispute courts, inheritance tax calculations, etc where they need a definitive number. You must note that this definitive number provided by these extensive reports does not necessarily mean someone is willing to pay you that amount.
When you are selling a business, even the most accurate opinion of value does not matter. A valuation is merely a starting point for negotiations. During negotiations, counteroffer prices may fluctuate as much as 10-15%. Many factors come into play into the final price such as supply and demand, availability of financing, attractiveness of the industry (software, high tech), buyer or seller compulsion, buyer strategic agenda, seller urgency, and so many more.
This isn’t to say that an opinion of value is unnecessary! Your asking price still needs to be from a defensible position. A defensible position starts from using proper fundamental techniques.
That’s why we are different. Our FSBO package does not just come with valuation service but also suggestions on pricing and negotiation strategies. If you are looking for a valuation that you can use as a guide to pricing your business for sale, consider the Evaluate Advisory FSBO package. Learn more here.
I have expensive capital equipment in my business that is newer (less than 5 years). Should my business be worth more than another similar business with the same earnings?
Many business brokers (wrongly) do not take into account CAPEX or Capital expenditures into their valuation model and for capital intensive businesses can be disastrous for producing the right Enterprise Value.
Proper valuation methods will account for annual estimated CAPEX adjusted SDE or EBITDA.
This is in essence similar to free cash flow to firm excluding changes in working capital.
In simple terms, if your annual SDE is $150,000 and your heavy equipment costs $200,000 and has a useful life of 20 years, that’s $20,000 of CAPEX a year. Your CAPEX adjusted SDE will then become $130,000. It’s a simple calculation with no inflation or required new equipment efficiency but it shows a point.
But what if your equipment is fully paid up and you just bought it 3 years ago? If the Enterprise Value is based on earnings only (goodwill) and includes fixed assets, how should you treat this owned asset? Can you add it to your asking price?
This is a more technical question that I can answer if I knew more about your business. Call the number above or submit an inquiry form to reach out to me.