- Methods of Valuation
- A Framework for Business Valuation
Your business is potentially your greatest asset, and it is essential to have a reliable assessment of its worth. The only problem is that business valuation is a dynamic discipline that includes a variety of different variables. How much is my company worth? What is the best strategy for a business valuation? What are the factors that drive the company’s value?
This whitepaper aims to give you some fundamental insights into the most common business valuation approaches. You’ll also learn how to value a business, starting with the standard structure of a business valuation. You should have a basic understanding and all the tools to perform an elementary business valuation.
Placing a value on your company is a complicated process. It needs the right mix of science and expertise. Company valuation is an art, not a science. Quote too low a figure, and you will undersell your company; aim too high, and you will never sell.
Determining fair value for a company is never an easy process. To the owner, the method of valuation is personal and emotional. Often, they have an unrealistic idea of how much their company is worth. To the buyer, the valuation process is far more objective. Also, is this a financial or strategic buyer? Both will look at “fair value” differently. Finding balance can prove to be extremely difficult.
A certified business valuation by an accredited Business Appraisal Florida team member takes strategic and in-depth analysis to determine an accurate estimation of a company’s worth. Numerous considerations are used in the process of setting a sale price and deciding whether an investor’s bid is fair. It takes more than just a number of numbers to value a business. However, the most important thing that can influence the valuation of a business is how much the purchaser is able to spend.
With that in mind, this whitepaper will try to answer a small business owners’ more stringent question: “How much is my company worth?”
III. Methods of Valuation
Business Valuations is not an empirical science, and there are various approaches to measure the worth of any business. Each of these approaches is based on varying financial facts and expectations that may result in a different valuation. For example, one way is based on the anticipation of potential cash flows, and the other is based on the value of the assets of a company.
Whatever approaches are used to value a business, you can prepare a statement of profits and profit/loss, as most clients request this document to determine the cost of products, sales, and operating expenses.
Discounted Cash Flow
From the buyer’s point of view, this is the most reliable way to value a business, and it allows the owner of the business to pay more attention to information such as trends in sales and profits and the capitalized value of the company. This valuation method represents the amount of capital expected by the investor to reach the market in the next few years, and with the basis of these cash flow estimates, the purchaser will determine their return on investment.
There are three critical questions one needs to answer to capitalize on future earning:
- Value: How much is the business worth today based on what it will earn in the future?
- The Rate of Return: What is the investor’s expected rate of return?
- Equity Share: How much equity will the investor get for their investment?
Once the investor has an estimate of the potential cash flow, the discount rate shall be calculated, taking into account the time value of the assets. This variable is determined by the capital expense of the purchaser and how sensitive it is to the company or the market.
To make it smoother, bear in mind that these two important variables have an effect on the valuation of your company when using this method: estimated profits to be made and how accurate such forecasts are.
The most common way to value a company is to determine the value of its hard assets. The assets usually purchased in a buy-sell process include merchandise, inventory, equipment, sales, office supply (hard assets) and intellectual properties, brands (the soft assets), and goodwill.
One of the most critical assets that you need to consider and evaluate in the buy-sell process is goodwill. From an accounting point of view, goodwill is defined as the difference between your business’s market value and the worth of your hard assets.
However, goodwill can also refer to the value of the loyalty of your business’s customers, and it’s connected to a good name, reputation for stellar products and customer service, experienced personnel, and favorable location. Most companies have a collection of intangible assets in the form of patents, people, special procedures, intellectual properties, licenses, and brand recognition that add to their value.
There are instances in which evaluating a business by asset appraisal is more efficient than the discounted cash flow method. For example, a money-losing restaurant that owns its own real estate (valued at $1 million) will benefit more from the asset-based valuation method, while a software company that estimates $3000,000 in profit this year but has few assets will gain a more profitable valuation with the discounted cash flow technique.
A discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment.
The Comparables Approach
Another way to value a company is to analyze the financial worth of comparable businesses that have sold in the recent past. However, the issue with this method is that it often leads owners to make wrong assumptions.
For instance, a small accounting firm might believe that since Deloitte is trading for twelve times last year’s earnings, their company is worth at least twelve times last year’s profit. However, in most situations, the reality is entirely different. Size, depth of management, not being driven by one or a few owners are just a few reasons why smaller company’s multiples of earnings can be a third to one-half of those in the same industry but Fortune 1000 in size.
IV. A Framework for Business Valuation
Any business owner who wishes to sell his or her company will benefit from knowing the fundamental science behind valuation and the variables that influence the value of the company. A correct estimation of the valuation of your company will make a customer or an investor consider your business, while a bad appraisal could have an effect on their decision.
So, how do you value a small business?
Here’s an outline that might help you get an accurate answer to your question: “How much is my company worth?”
Step One: Calculate the Seller’s Discretionary Cash Flow (SDCF)
The starting point of any business valuation, whether big or small, should be to determine the Seller’s Discretionary Cash Flow (SDCF) or the Total Owner’s Benefit.
SDCF refers to the pre-tax earnings of the business before the owner’s salary, non-cash costs, charitable donations, leisure activities, business-related expenses, any personal charges, as well as one-time expenses like the settlement of a lawsuit.
The great thing about SDCF is that it gives business owners an idea of their company’s actual cash flow potential.
How to determine SDCF:
- Begin with the pre-tax earnings of your business;
- Add non-operating costs and subtract non-operating earnings;
- Add interest expenses and deduct interest income;
- If necessary, add one-time charges, and subtract non-recurring revenue;
Step Two: Determine the SDCF Multiplier
Most businesses are traded for between one and three times the SDCF. This value is known as the SDCF multiplier, and it depends on several factors, such as market trends, industry, company size, owner risk, the company’s assets, and so on.
However, the most significant variable influencing SDCF is owner risk – the dependence/independence of the business from the owner. If a company is highly attached to the owner, it can be difficult to transfer it to the new ownership. In such a scenario, it will affect the business’ value. Market trends are also crucial. For instance, if you are selling your company in a niche that is expected to decline in the future, you can expect the SDCF multiplier to be lower than average.
Step Three: Add Business Assets and Deduct Business Liabilities
At the end of the business valuation process, you need to consider the assets and liabilities that are not contained in the SDCF multiplier.
Most business owners include intangible assets, such as reputation, goodwill, or personnel, in their SDCF multiplier. Likewise, equipment, furniture, and fixtures are also accounted for. However, as some experts point out, some accessible databases don’t contain inventory in their SDCF multiplier. That said, it needs to be annexed separately by the business owners.
Other tangible assets, such as real estate or cash, are not included in the SDCF multiplier by most business owners.
In the end, the company valuation formula should look something like this:
Company Estimated Value = SDCF * Multiplier + Assets not contained in the SDCF multiplier – Business liabilities.
Business valuation is a dynamic procedure, and various businesses have their own ways of assessing the value of their companies. If you are not sure which valuation approach is right for you, a competent evaluator will help you set a sale price and decide whether an investor’s bid is realistic.
Business Appraisal Florida can help you value your company. Whether you are pondering a prospective business transaction, launching into succession planning, or encountering financial distress, our team effectively assimilates the information, makes the tough calls, and renders a robust valuation to help clients reach their objective.