What is a business valuation?
A business valuation estimates the monetary worth of an enterprise. The value can be important for financial reporting, dividing shareholdings, selling all or some of the business, creating succession plans, or getting finance. It’s handy to know how to value your business – even if your best bet is to get a professional to do the work for you.
It’s important to understand that a business valuation doesn’t establish a selling price. It may play a role in negotiations but the ultimate selling price depends on a large variety of factors including demand, market conditions, competition, intangible assets, and future prospects.
How to value a business: 6 methods
1. Book valuation
The book value is calculated by examining your balance sheet. It uses the formula: value = assets – liabilities. Put another way, it’s everything the business owns minus everything it owes.
Assets include things like land, buildings, inventory, vehicles, equipment, cash, and accounts receivable (money owed by customers). Intellectual property such as copyrights, trademarks and patents are also assets.
In this model, a business is valued as the sum of its parts. If it owned $10M in assets and owed $5M in debts, the book value would be $5M.
2. Liquidation value
The liquidation value is similar to the book value. It calculates what the owner would be left with if they closed the business, sold the assets and paid all the debts. The subtle difference is that liquidation value is based on the market value (not the book value) of assets. It’s an important distinction because the market value reflects what someone would pay for the asset. The book value is the purchase price minus depreciation, so it’s more of a theoretical number.
3. Earnings-based valuation
It’s common to value a business by looking at how much money it makes for its owners. In these cases, the value of the business is set as a multiple of annual earnings. This business value calculation uses the formula: value = earnings x multiplier.
The multiplier is a big variable in this equation. It can range from two all the way up to double digits. A business that earns $350,000 per year with a multiplier of two, would be valued at $700,000. But if the multiplier is five, it would be valued at $1.75M.
Bigger multipliers are typically given to businesses that have loyal, long-term customers, exclusivity in their local market, intellectual property or hard-to-replicate business models or market positions. Certain industries may have conventionally accepted multipliers.
The earnings number is also important. It could be the net profit or EBITDA. EBITDA is a bigger number than net profit because it includes all the money made before paying taxes, before paying interest on loans, and before accounting for the cost of depreciating (aging) assets.
4. Times-revenue valuation
The times-revenue valuation is like the earnings-based valuation but instead of using profit as the starting figure, it uses revenue (or sales). It follows the formula: value = revenue x multiplier.
5. Discounted cash flow valuation
Rather than multiplying profit or revenue to arrive at a business valuation, you can multiply free cash flow instead. Free cash flow is the annual profits left after paying for any maintenance or upgrades the business requires. This valuation uses the formula: value = free cash flow x multiplier.
Calculating free cash flow is not as straightforward as calculating revenue, EBITDA or net profit. As a result, this method tends not to be as common with small businesses. A trained business valuer will be able to estimate which of methods 3, 4 or 5 would provide the most flattering number to use in a negotiation.
6. Entry-cost valuation
An entry-cost valuation asks what it would cost to start a business like the one being valued. If you could build an equivalent business for $50,000, then the existing business is probably worth $50,000 too.
Of course adjustments have to be made for the hassle of starting from scratch, the time involved in getting it up to speed, and the investment needed to build goodwill with customers.
The entry-cost business valuation may sometimes be used to sense-check another form of valuation. Someone who’s wondering how to value a business might first try the times-revenue method and get a value of $300,000, before trying the entry-cost valuation and getting just $100,000. This valuer knows they’ll need to do some further analysis to land on the true value of the business.
Valuing a business is not a complete science
You can calculate business value by referring to:
- the sum of its parts (book value and liquidation methods)
- its ability to earn money for its owners (earnings-based, times-revenue, discounted cash flow methods)
- the cost of building an equivalent business from scratch
Incidentally, the book value (or net worth) of a business is identified on your balance sheet. Your accountant or bookkeeper will prepare a balance sheet at the end of each financial year at the very least. Or if you use software like Xero, you can create a balance sheet whenever you want one.
But when it comes to selling, there are many reasons why your business might be worth more (or less) than the valuation in the eyes of a buyer.
Nevertheless, these analyses can help set expectations and guide negotiations – be they with an outright buyer, an investor, or even with a lender who’s looking for security. Get more tips in the guide to succession planning.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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