Approaches to a Successful Business Valuation
Welcome to the second half of our two-part series on determining the value of a small business. If you missed the first post, be sure to check it out here first: Keys to Determine the Value of a Small Business – Part One.
In this second post, we’ll dive into the different approaches that are extremely useful in accurately valuing your business’s assets and liabilities. We’ve got a lot of information to cover, so let’s get started!
There are really four business valuation methods (nested within three approaches) that you need to be aware of. Each uses a different aspect or variable of a business to calculate its numerical value—either a business’s income, assets, or using market data on similar companies.
Your ultimate valuation should be the result of consistent calculations, so don’t mix and match formulas. That said, doing the math is free, so go ahead and plug your earnings numbers into different formulas, and compare. Investigate numbers that don’t seem right, and don’t be afraid to call in an accountant for extra help.
1. Income Approach
The income approach to business valuation determines the amount of income a business can expect to generate in the future. If you want to take the income approach, you can choose between two commonly used valuation methods.
Discounted cash flow method: This method determines the present value of a business’s future cash flow. The business’s cash-flow forecast is adjusted (or discounted) according to the risk involved in purchasing the business. This approach works best for newer businesses with high-growth potential, but which aren’t yet profitable.
Capitalization of earnings method: The capitalization of earnings method also calculates a business’s future profitability, taking into account the business’s cash flow, annual rate of return (or ROI), and its expected value. But where the discounted cash flow method accounts for more fluctuations in a business’s financial future, the capitalization method assumes that calculations for a single period of time will continue in the future. So, established businesses with stable profitability often use this valuation approach.
Most online business valuation calculators use a variation of the income approach. But if you have more financial information on hand, you can try a more comprehensive business valuation tool that includes both profit and revenue, as well as assets and liability, in the calculation.
2. Asset-Driven Approach
Another common method attributes value to a businesses based solely on its assets. In particular, the Adjusted Net Asset Method calculates the difference between a business’s assets—including equipment, property, and inventory, and intangible assets—and its liabilities, both of which are adjusted to their fair market values. Asset valuations are also a great tool for internal use, and can help you keep track of spending and capital resources.
To do an asset-driven assessment, you’ll make a list of your assets and assign them a monetary value. For equipment or other depreciating assets, that value is usually somewhere between the sale price and the depreciated value. A good rule of thumb is to estimate how much a piece of a equipment would sell for today, and use that number.
Because you’re familiar with your own equipment and production, you can make pretty accurate estimates of each of your asset’s value and depreciation. Even if you don’t adjust the asset’s worth according to the current market, you can still get a good sense of a business’s material value. This method is especially useful if your business mostly holds investments or real estate; isn’t profitable; or if you’re seeking to liquidate. In any of those cases, buyers will be interested in the individual value of your investments or equipment.
3. Market Approach
As you can deduce from its name, the market approach to valuing a business determines a company’s value based on the purchases and sales of comparable companies within the same industry. This approach will specifically help you determine an appropriate selling or purchase price based on your local market. Any business can use this approach to business valuation, as long as they can gather sufficient, relevant data on which to compare their business. It can be an especially useful approach for rapidly growing businesses and industries.
What to Do if You Plan to Sell Your Business
If you’re serious about looking for a buyer, be mindful of the impact that selling your business will have on your employees. In the exploratory stages, it’s a good idea to keep things confidential. Even if you’re committed to ensuring that your employees are taken care of, news that you plan to sell your company will likely impact the work environment.
So, even before you begin valuing your business, decide how much information to share with your employees. Depending on your team and your management approach, you might choose to include everyone in the process—and if you don’t personally handle your business’s finances and tax filings, there’s a good chance your employees will be involved, anyway.
In that case, you might want to consider a non-disclosure agreement. Keep in mind, too, that both your business’s partnerships and your customers will be affected when your business is sold. Although a sale may be far in the future, these relationships will start to change as soon as you announce plans to sell your company.
Learning How to Value a Business Is Important, Regardless
Whether or not you’re valuing your business to prepare for a sale, having an accurate number in hand can only be positive. Once you’re confident in your valuation, you can mobilize your knowledge about your assets and earnings to make decisive improvements or necessary changes.
No matter where you are in your business’s lifecycle, learning how determine a business’s value is a great way to better understand your own business’s finances and assets within the context of your industry. Plus, knowing the value of your business can help you navigate any unexpected market turns or inbound offers.
And if or when the time comes to sell, you can start thinking about how to maximize your profit as you transfer ownership.
Let us know where you are with determining the value of your business. Leave a comment below. And, be sure to check out the services that Flagship Financial can provide to business owners like you.