Business Valuation

KEY TAKEAWAYS

  • Learn about the different types of valuation methods and approaches
  • Understand the big driver in business valuations of private companies (hint: it’s about risk)
  • Business valuation is complex and thus, there is no “one size fits all” answer to many assignments and questions
  • Understand that different purposes for business valuation require different approaches and strategies in order to be accurate

What is business valuation?

Business valuation is exactly what it sounds like – the process of valuing a business.  In most cases, this refers to private businesses.  An entire profession has been developed in the last 40 years to focus on the blend of art and science required to value a business.

How does business valuation work?

Business valuation works by assessing the risk in a particular business and examining the entire business model.  In most instances, the foundation of a valuation will be the financials of the business and how much income, EBITDA (earnings before interest, taxes, depreciation, and amortization), or cash flow it produces.  Because a business is viewed as an investment (just like an investment in IBM stock), the financial performance and risk in the business are the cornerstones to a solid business valuation estimate.

Why is business valuation important?

Business valuation is important for a variety of reasons.  First, it may be required in a legal proceeding (such as divorce or litigation).  Second, valuation is important because it helps the business owner understand where / how the company is doing.  Because relying on revenue or increases in profitability can be somewhat misleading, business valuation is the critical measure of success.  After all, isn’t that what we pay attention to when looking at public stocks?  Business valuation for private entities can provide strategic insights and help drive plans to create more business value that are independent of driving revenue.  In essence, it is the single most important metric that private business owners should focus on.

How to calculate business valuation / How to determine what a business is worth

To calculate a business valuation, solid financial information is required; meaning, typically a balance sheet and income statement over an historic period (5 years is most common) is the best starting point.  Once this information is obtained, a series of information collection meetings or documents will help assess the risk inherent in the business then, the person performing the valuation will choose the approaches and methods that are right for the business valuation assignment.

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Business valuation methods and approaches

Just like in real estate valuations, there are three primary approaches in business valuation: the asset approach, the market approach, and the income approach. The business valuation methods (they are more accurately framed as approaches) are the cornerstone of the business valuation profession. Within each of these approaches, there are several methods that are used to arrive at business value. 

The asset approach estimates the value of the business using both the tangible and intangible assets of the business.  The market approach uses comparable transactions, if appropriate and available, to estimate value based on actual deals that have been done in the market while the income approach uses either a capitalization of earnings or a discounted cash flow method. In a business valuation assignment, a valuation professional must use the approaches and business valuation methods that are most appropriate to the assignment. For example, it would be more appropriate to use an asset approach when valuing a heavy civil construction company that has a lot of new equipment and is not cash flowing particularly well, than it would be to use the same approach to value an accounting firm that has very little in the way of fixed or hard assets.  Often, the valuation professional will use a combination of approaches and methods that are appropriate for the company as well as the purpose of the valuation.

Business valuation calculators – Can I use a business valuation calculator for my business?

The answer, like many answers to complicated questions is, well, complicated.  For certain types of valuations, business owners will want to get a formal valuation done by an individual credentialed in business valuation.  Often times, these more complicated forms of valuation include valuations for estate planning, buying or selling shares in a private entity between partners (especially when contentious), divorce proceedings where a business owner is one of the individuals involved, or other types of litigation.  Because value is truly in the eye of the beholder, the valuation is driven by any number of factors.  Really, what it comes down to, is what is the risk in a particular business?  Because of the numerous variables that must be considered in performing a business valuation, business valuation calculators are severely limited in their ability to capture these variabilities.

So what happens if you want a valuation but don’t need one for the reasons referenced above?  Can you use a calculator?  The answer is yes, although it still may prove somewhat misleading.  In general, business valuation calculators cannot consider situations such as highly variable economic conditions, changes in market conditions, or significant changes in business performance.  As an example, if a business valuation calculator were used to value a residential home builder after the great recession of 2008 had already started, the business valuation calculator would have most likely overestimated the value of the residential home builder because it would not have been able to take into account the dramatic impact the recession had on home building.  Additionally, the calculator would be focused on the prior year’s economic performance of the homebuilder which most likely would have been quite good further exacerbating the issue of over valuation.  Furthermore, because many of the calculators rely heavily on data from prior transactions that have occurred in different economic times or during different phases of market ebbs or flows, their conclusions may yield unusually high or low valuations. 

If accuracy is your aim, it is best to hire a professional who also has experience in doing valuations for the specific reason you need one done.

Which business valuation method is best?

While valuation assignments may call for a variety of different methods, the most common valuation method used is the income approach method(s) such as the discounted cash flow method and the capitalization method. The IRS and most experts agree that using the income approach to arrive at value should be the pre-eminent method as it, is the thing that most hypothetical (and real) investors will be focused on.

How to get a business valuation

Getting a business valuation is pretty simple.  There are online calculators which on occasion, can be helpful in arriving at value yet as already discussed, online calculators can also be terribly misleading.  The most accurate and reliable way to get a business valuation is to hire a professional valuation expert.  This expert will have experience in the type of valuation you need completed.  Valuations for different reasons often require different experts.  For example, a valuation for a divorce proceeding, because the methodology used in divorce valuations is different than a traditional valuation for an SBA loan, would require an expert in business valuation for divorce.  Make sure you seek an expert who is familiar with the purpose of the business valuation..

How to value a business based on revenue

Assuming all businesses get valued based on revenue is a common mistake.  Indeed, some businesses, particularly fast-growing high tech and consumer goods companies may get valued based on a multiple of revenue.  Typically, there will be a multiple applied to a trailing twelve-month revenue stream to arrive at a valuation figure.  While this may appear to be a very attractive way that a business could or should be valued, especially if you are a seller, it often leads to difficult discussions because at some point, an investor of a business must get some sort of return on the investment made.  To make that happen, the business must at some point become cash flow positive. 

Many business owners may hear that their competitor just sold for a multiple of revenue and believe they should be valued on a multiple of revenue as well.  Without understating the full risk profile and strategy of a business and in this case, of the competitor, that may not prove to be entirely accurate.  For example, let us assume a business has $5,000,000 in revenue and has $1,000,000 in cash flow and that an offer was made to the owner of said business for $5,000,000.  That equates to a 1x multiple of revenue or a 5x multiple on cash flow.  If the buyer submitted their offer based on the $1,000,000 in cash flow (which you, as an outsider, most likely would not know) and was intending to pay 5x that number, then the multiple on revenue just happens to be a biproduct of the valuation, not the approach used.  To stay with this example, if a virtually identical competitor to the company was doing $3,000,000 in revenue and was also doing $1,000,000 in cash flow, and you were to assume that the 1x multiple of revenue was the most reliable approach to use, then the valuation for the second firm would be too low at $3,000,000 if the prevailing market multiple on cash flow was 5x.  As you can see, valuation is a very intricate blend of art and science and relying on a rule of thumb or anecdotal information can be misleading, especially when focusing on multiples on revenue.

How do you value a business based on cash flow?

Valuing a business based on cash flow is the most common method the valuation community, as well as investors, will use to value a business.  To do so, there are two primary methods, with one being more popular than the other.  One method is to take an historic cash flow benefit stream and divide it by a capitalization rate to arrive at an estimate of value.  This is known as the capitalization method.  Finding the correct historic cash flow benefit stream can depend on any number of factors.  For example, an investor or valuation professional may use any of the following when looking at cash flow as the benefit stream: a straight line 5 year average; a weighted average of the last 5 years placing different weights on different years, the most recent year, or the trailing twelve month period.  All of these may yield wildly different results and thus it takes the trained eye and a deep understanding of the business to accurately use this method.  The second method is the discounted cash flow method.  The discounted cash flow method projects performance of the business into the future and then discounts that back, based on risk in that series of cash flows, to a present value.  Projecting future performance is often very difficult to accurately predict and as such, the “risk” in these cash flows is typically greater.  This risk assessment relies on the judgement of the individual who is conducting the valuation and the risk they see in the business.  As you can imagine, perception of risk is significant when developing these types of valuation methods and can yield to significantly different results. This risk assessment translates to a discount rate which is the denominator while cash flow is the numerator to arrive at a valuation estimate. 

It is important to note that the economic benefit stream chosen to either capitalize or project can vary as well and is very important.  This benefit stream can be net income (earnings), seller’s discretionary earnings, EBITDA (earnings before interest, taxes, depreciation, and amortization), cash flow, cash flow to invested capital or free cash flow.  All of these benefit streams may be adjusted to add or subtract any one time or non-recurring events as well to further complicate things.  Once the benefit stream is appropriately adjusted for the purpose of the valuation, then the appropriate approaches and methods will be used.

What is goodwill in business valuation and how to value the goodwill of a business

Valuing goodwill in a business is often one of the most challenging elements of a valuation assignment.  In particular, many a business owner wants to make sure they receive value for the goodwill contained in their business.  Since this is such a difficult thing to value, it often becomes a topic of debate between buyers and sellers when looking at business value.  Ultimately, the value of goodwill should be reflected in the earnings (income) or cash flow that the business generate.  If the company has a solid brand or reputation in the market, that should yield more business for the company and thus, part of the income is attributable to the goodwill of the entity.  The technical aspects of valuing goodwill are difficult but suffice it to say; the value of goodwill is directly reflected in income or cash flow generated.  So as long as an income approach is used in valuing the company, that will take into account the value of goodwill and the estimate will be accurate.

How to value business assets

Business assets can be valued individually.  Fixed equipment such as machinery, can typically be valued by replacement cost or remaining useful life while goodwill requires a more difficult calculation.  To value fixed equipment such as machinery, there are often appraisers for these types of equipment that specialize.  They can often be used in a business valuation, particularly if the business valuation will be relying on an asset approach.

Public comparables valuation

Public comparables valuation is a method within the market approach whereby the subject of the valuation (the company you are valuing) uses the public market as a proxy for the valuation of the company.  To arrive at a valuation using this method, a valuation expert will look to find as many similar companies to the subject of the valuation as possible.  These similarities may include the market in which the company works, the gross margin profile, net profit profile (both as a % of revenue by the way) and other factors.  Once the comparables set is determined, then the appraiser will look to a metric that can be used to extrapolate the valuation to the subject.  A multiple on EBITDA is but one example.  Once this step is complete, the appraiser will then discount this multiple to compensate for the difference in size and the fact that the public market is freely tradeable whereas stock in a private company is NOT freely tradeable.  This discount, often called a discount for lack of marketability, is then applied to arrive at an estimate applicable to a privately held enterprise.  The discount for lack of marketability reflects the fact that the stock of a privately held entity cannot be traded in an open market like a public company stock can. 

How to value a service business

Because service businesses are often “asset light” businesses, they typically will not rely on the asset approach to arrive at a valuation.  In most cases, a service business will be valued primarily by the income approach (how much income or cash flow does the business generate) and / or by the market approach (comparable businesses that have sold in the private market).  There are private market databases that track some of this data; however, they record a fraction of the number of transactions that get completed in a particular market in a year.  In most instances, a combination of the income approach and market approach are the best methods for valuing a service business.

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How to value an internet business

Valuing an internet business can be challenging, especially if the business is pre-profit or pre-revenue.  In most cases, valuing an internet business is best performed by using a DCF analysis (see next question).  Because many of these businesses are growing very quickly, a DCF or a multiple of revenue is often used.

How to value a business for partner buyout

Many businesses will have a buy/sell agreement between its partners.  The buy/sell agreement is an agreement that governs and outlines the process by which one partner can buy another partner’s interest out of the business.  Typically, a buy/sell agreement will take into account many facets of the business and will govern what is to happen in the buyout.  The worst possible thing we’ve seen in buy/sell agreements is a formula.  Using a formula in an agreement such as this leaves little room for the aspects of “life” that occur such as significant spikes or drops in financial performance, economic issues such as recessions and booms, and other events.  Valuing a business for a partner buyout, absent a buy/sell agreement that specifically details the process, will require a valuation expert.  Relying on an online calculator to do so is fraught with risk and can create tension in an already potentially contentious situation.  We recommend hiring a professional that can accurately and independently provide a valuation estimate.

How to determine market value of a business

Determining the market value of a business usually refers to “what’s the business worth in the open market.”  We would typically refer to this as an enterprise value.  Enterprise value or market value is what a hypothetical buyer would pay for a business.  Using a residential housing reference, we liken the enterprise value or market value to the value of your home if you decided to sell it.  In essence, it is the value of both equity and debt.  Sticking with the residential housing reference, if you sold your house for $1,000,000 and owed the bank $300,000 for the mortgage, when you sold it the equation would look like this:

Market value (or enterprise value) = Equity value + Debt value

$1,000,000 = $700,000 + $300,000

You pay the bank back their $300,000 and you keep $700,000.  It’s the same in business when looking at the market value (in this instance, the market value is $1,000,000)

What is capitalization rate in business valuations?

A capitalization rate in business valuation is the most critical component of getting an accurate business valuation.  The capitalization rate is the denominator in the equation to arrive at value, while the numerator is the economic benefit stream (such as income, EBITDA, cash flow, or seller’s discretionary earnings).  It is a metric that is built up by a business valuation expert and is used to convert the economic benefit stream to a value.  It considers many factors and since it is a derivative of the discount rate, risk in the economic benefit stream is the primary driver.  The difference between a discount rate and the capitalization rate is long term growth rate.  The discount rate is applied to discount future income while the cap rate is used typically to a more historic looking approach such as the capitalization of income.  The relationship between the two is simple; the cap rate is the discount rate without the projected long term growth rate of future income.  The most important takeaway in this is that risk in the business is the single biggest input that influences value, no matter what approach or method is used.

What is a multiple in business valuation?

The multiple in a business valuation usually refers to the multiple that is applied to an economic benefit stream such as income, cash flow, or EBITDA (earnings before interest, taxes, depreciation, and amortization).  This multiple is the inverse of the capitalization rate, which is derived from the discount rate. 

What is business combination valuation reserve?

Business combination valuation reserve (BCVR) is a part of a consolidating exercise when consolidating financial statements of two or more companies.  In essence, it is a pre-acquisition equity calculation that needs to be debited when consolidating the statements of the two entities.  Given the variability in valuations in private companies, creating a reserve account on the balance sheet is common to allow for a change in value when the value of that acquisition (or asset) has changed.

How to value a business for investors

Valuing a business for investors typically uses an income-based approach and often, a discounted cash flow (DCF) method.  This allows the valuation expert the opportunity to project income, EBITDA, or cash flow into the future based upon a series of assumptions, and then discount that back to a present value.  This allows the investor an opportunity to evaluate the return on that investment (ROI, or in some cases an internal rate of return or IRR) which is critical to the investor and whether they make the investment given the risk. 

Financial buyers vs strategic buyers

Financial buyers are buyers that typically look more significantly to the financial performance of the business and are most likely to focus on the returns generated on the particular investment.  Strategic buyers are more likely to look to the synergies created in an acquisition, for example, and thus will take these synergies into account when performing the valuation as to whether they proceed with the acquisition.  Synergies may include things such as the acquiring company having a new product that could be sold into the target company’s existing customer base, as well as elimination of redundant expenses.

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What is a DCF analysis?

A DCF analysis is a method by which an investor or buyer can value a business.  DCF, or discounted cash flow, relies on assumptions in a projection model to arrive at series of cash flows into the future.  These cash flows are then discounted back to a present value (PV) and the cash flows are then added up, along with the calculation of a terminal value in the last period of the projection, to arrive at a business valuation estimate.  The discount rate is built up to a rate that is appropriate for the business, given the risk perceived by the investor in this particular investment.

How to do a DCF analysis

A DCF or discounted cash flow analysis requires several things.  Since it is a projection into the future, the Company has to project its financial statements into the future and arrive at a cash flow number.  To arrive at a cash flow number for each year in the period projected, the company needs to project an income statement and a balance sheet, and then perform a reconciliation to a cash flow figure (or create a cash flow statement).  These statements do not need to be overly complex; rather, focusing on the main elements can be a great place to start.  Once the projection model is complete, the DCF requires the build up of a discount rate.  The components that go in to building up the discount rate are:

  • Risk free rate: This is usually the long terms US treasury rate (20 yrs is most commonly used)
  • Risk premium: This is a published figure that identifies the premium applicable to owning public stocks relative to the risk-free rate. Said another way, it’s the difference in the rate of return between owning stocks v. us treasuries.
  • Size premium: Because most DCF analysis in business valuation are being performed on private companies, there is a size premium that is applicable. In other words, the bigger the company the lower the risk generally speaking.  This gets reflected in the discount rate to make it applicable to a private company.
  • Industry risk premium: This is a factor applied to specific industries as some industries are more risky than others.
  • Specific company risk: this is the subjective element to the valuation. When an investor or business valuation expert is assessing risk in the cash flows, he or she will take into account the specific risk factors applicable to THAT business.  These risk factors may include; key man risk, customer concentration, project based business, lack of management team, lack of financial controls, etc.  Our CoPilot risk profiling application represents a methodology for assessing this risk

Once these components have been determined, they combine or “build up” to the discount rate that is used in the discounted cash flow method of business valuation.

What is SDE in business valuation?

SDE in business valuation stands for seller’s discretionary earnings.  SDE is the equivalent of adjusted income (earnings).  The adjustments that are made to income include all the benefits that the seller may receive or take out of the business as the owner of the business, also known as “perks.”  These perks can be things such as a company car that is also used for personal purposes, travel that is both business and personal, personal or family member fuel for automobiles, personal or family member mobile devices, and charitable contributions to name a few.  These expenses are added back to the earnings thus creating seller’s discretionary earnings.

How to create value in a business

Did you know that without increasing profit or driving more revenue, you can increase value in a business?  Simply put; it is all about risk.  By lowering risk in a business, you create a more sustainable business and thus in the eyes of the investor or valuation expert.  Because the discount rate (or the capitalization rate which is a derivative of the discount rate) is an assessment of risk, my lowering the risk you increase the value.  The capitalization rate, which comes from the discount rate (as you recall, is based on the risk in the business), is the denominator.  The inverse of the capitalization rate is roughly the equivalent of the multiple that is so commonly discussed in the marketplace.  So, a capitalization rate of 25% is the same as a multiple of 4.  A capitalization rate of 50% is a multiple of 2.  To reiterate, the increase in the capitalization rate results in a lower valuation.  What increases the cap rate?  Risk.  Lower the risk, lower the cap rate, raise the valuation to create value in a business.

How can internal audit add value to the business?

Having an audit completed on a business can enhance business value primarily because it is a review of a business’ financial controls.  By having audits done, particularly having them completed annually, is a great way to increase the value of the company as it shows financial discipline and focus on controls necessary.  From an outsider’s perspective (a bank, investors, insurance provides, vendors, etc), it shows that a business owner is committed to high standards when it comes to the financials of the business.

How does branding add value to a business?

Branding adds value to a business by enhancing a businesses position in the marketplace.  A company with a fantastic and loyal brand (product or corporate identity) usually has a premier position in their market.  Combine that with a solid reputation, and you’ve got an industry leader and something that many buyers will desire.  Having a solid brand provides an enhanced view of the business in terms of sustainability and should provide more steady and higher levels of cash flow thus resulting in a higher valuation.

What is business valuation services?

Business valuation services is the art of providing a business valuation.  Business valuation differs from other accounting and finance functions and often requires specific training and expertise. 

Who does business valuations?

Accounts, finance professionals, and business valuation experts often perform these functions (as well as investment bankers).

Business valuation companies

Business valuations can be completed by any number of individuals.  Most important is to determine what the purpose of the valuation is and then to source an individual or a firm that has experience in dealing with that purpose.  Specifically, you would not want a business valuation firm that focuses on divorce cases to do a valuation for exploring whether a business owner should go to market.  This is because the purpose drives the engagement and can often yield different results.  Moreover, having someone that understands and has experience in dealing with the valuation for the purpose outlined will yield more accurate results.

How much does a business valuation cost?

Depending on the purpose of the valuation, business valuation costs can vary widely from expert to expert.  In general, a low end, “back of the envelope” type valuation from a valuation expert might cost as little as $5,000 while a report that is more significant in its analysis and research may exceed $20,000.

How long does a business valuation take?

A business valuation should generally take 4-8 weeks depending on the complexities of the assignment and the business.  This timeline can be influenced by how readily available information is on the business.

How to value a business quickly

Rules of thumb, gathered from conversations at cocktail parties or from industry experts that talk about the valuation multiples within the industry are often the easiest ways to value a business quickly.  Like any anecdotal experience, it can be very misleading given the fact that it has no point of reference relative to the private business to which you wish to apply it. 

How much is my business worth?

What your business is worth can vary by any number of factors or reasons.  Just like many subjective elements in life, value is in the eye of the beholder.  Typically, your business is worth a multiple of the amount of cash that it throws off, often referred to as cash flow.  The more cash flow a business has, the more valuable it generally is.  I say generally, because risk factors play a significant part in cash flow.  For example, if a business increases it’s cash flow in one year by $1,000,000, one would think that the valuation should increase by a multiple of that; however, if all of that increase in cash flow came as the result of a one time project that was completed in a particular year, there may be reason to consider that as a one time event and thus, not as much of a contributor to the value as one would think.

How to determine the value of a business

To determine the value of a business, a business valuation professional will go through an extensive analysis of the financials of the business as well as other facets in an effort to understand how the business operates.  In our book Harvest: The Definitive Guide to Selling Your Business we outline these facets as risk factors called value drivers.  In Harvest, we organize the risk categories into five distinct value drivers; Financial, Organizational, Customer, Employee, and Strategic.  By organizing risk this way, it becomes much more manageable to assess the risk in each of these categories.  As a result, we have now taken this risk profiling system and built it into an intuitive software application called CoPilot

 

Once the risk profile is complete, the business valuation professional will assign a level of significance to these factors in an effort to arrive at, conceptually, whether the business is “high, medium, or low” risk.  This then helps the valuation expert zero in on the appropriate business valuation methods and approaches that should be used and thus, arrive at the most accurate conclusion possible.

How do I get a business valuation?

Getting a business valuation is easy.  The first step is to clearly understand the objective of the valuation.  Because business valuations can be used in a variety of different circumstances, understanding the purpose of the valuation clearly will help you decide who needs to do the valuation for you.  Next, go to your team of advisors (attorneys, accountants, bankers) and discuss with them why you need a business valuation and ask them for the names of several reputable firms or individuals that perform these types of valuations.  You can also do an internet search, but we have found that the trusted advisor network is the most reliable way to find someone reputable that can assist you with the need.

Get in touch with the Class VI business valuation experts

If you are considering buying or selling a company and have questions about the process or how an investment bank might be able to assist, please feel free to contact us or reach out to [email protected] personally and we will discuss your goals and objectives and the tools we have to assist you.

If you’d like to learn more about how prepared your business currently is for a sale, click the red banner above to take our CoPilot Assessment. CoPilot will help you identify what specific risks your business has that decrease company value and reduce your certainty of close. The assessment identifies over 90 different types of potential risks your company could have that will make your business less valuable in the eyes of an investor. Get the test ahead of time and build value today with CoPilot.

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