How Do You Calculate the Value of a Business?
You may want to know the value of your business for several important reasons. For example, you may be approached by an interested buyer, you may plan to sell the business in the near future, or you may want to establish a value for insurance purposes (e.g., replacement costs of losing your business from a fire). What a potential buyer will pay for your business generally depends on two key factors: return on investment (ROI) and relative risk. A more favorable ROI and lower business risk may command a higher sale price and vice versa.
As an entrepreneur, you probably have poured a significant amount of time, money and sweat equity into creating and growing your business. ROI is a measure of how much value or additional money you have earned — your return or net profit after you pay all your business expenses (taxes, rent, salaries, etc.) — as a percentage of your beginning investment. The basic ROI formula is:
ROI (%) = (Return/Original Investment) x 100%
For example, let’s assume your initial investment in the business is $100,000, and your net profit (or return on your original investment) is $20,000. Then your ROI would be 20%:
ROI (%) = ($20,000/$100,000) x 100% = 20%
What may be considered a favorable ROI, however, should also be balanced with risk. Generally, when an individual is taking on considerable risk in buying a business, the potential ROI also should be higher to compensate for the relatively high level of risk the new owner is assuming. Buying higher risk investments that could potentially earn you more money may also decrease in value over time because of their volatility. A new buyer of your business needs to be comfortable with the balance between your current ROI and risk of assuming ownership. A 10-year-old restaurant with increasing profits over the past five years may involve less risk for a new buyer than a two-year-old restaurant with flat revenues.
In order to help mitigate the risk of future business failure, a potential buyer also may want to see evidence of the following qualities of your business:
- Predictable key drivers of new sales
- Potential for business growth/expansion
- Strong established relationships with suppliers
- A loyal, productive and motivated workforce
- High percentage of repeat sales and customers
- No past or present lawsuits or tax complications
- Established branding with clean trademark, copyright and legal history
- Documented systems and processes for efficient business operations
Four Common Business Valuation Methods
There are a variety of approaches to arrive at the current estimated value of your business. Below are four common business valuation methods and the pros and cons of each:
1. Book Value (Asset-Based Method) – This method considers your assets and liabilities — the accounting figures recorded on the books. The formula is quite simple: business value equals assets minus liabilities. Your business assets include anything that has value that can be converted to cash, like real estate, equipment or inventory. Liabilities include business debts, like a commercial mortgage or bank loan taken out to purchase capital equipment. If your assets are $100,000, and your liabilities are $30,000, then your business valuation would come out to $70,000.
o Pro: This method may be preferred when others result in giving you a lower business valuation.
o Con: This method may not account for important intangible aspects of your business — such as your long-standing reputation in the community and loyal customer base — which could boost the value of your business in the eyes of potential buyers or investors.
2. Discounted Cash Flow – This method of valuation focuses on the future performance of your business rather than historical data. If your cash flows are consistent and predictable, your business may be more likely to appraise at a higher value. This method estimates the cash flow your business is projected to produce into perpetuity and then discounts this back into current dollars (called net present value or NPV), while also accounting for the level of financial risk indicated by your business or industry. For example, a high-tech software business is usually considered higher risk than a retail shoe store. Our Business Valuation Calculator uses the discounted cash flow method to estimate the value of your business.
- Pro: Many business owners prefer this method of valuation because it focuses exclusively on cash flow, which is often viewed as an influential factor in determining the value of a business.
- Con: This method is based on numerous estimates and projections of cash flow into the future, and if those figures are off base or unrealistic, your business value may be overinflated or underestimated.
3. Revenue/Earnings – This method takes your business’s revenue (gross income) or earnings (net profit after all business expenses are paid) and uses an industry multiplier to come up with a value. If your industry standard multiple is five times sales, and your sales revenue last year was $80,000, then your business would be valued at $400,000 using this method.
An alternate version of this method examines your current earnings, makes projections about your future earnings and uses a multiple to arrive at a business valuation. The measure of earnings can be either EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization). (This McKinsey & Company report, which examines S&P 500 companies, illustrates the variability of multiples within different industry sectors.)
- Pro: This method offers you a relatively easy and straightforward way to establish a rough estimate of the value of your business.
- Con: Because this method involves making projections about the future revenue or earnings of your business — which may likely fluctuate for a variety of reasons in the coming years — it may lack precision in its estimating approach. For instance, a national recession may create a slump in sales while the closing of a competitor near you could give your business a boost.
4. Market Comparison – A fourth method of evaluation compares businesses in the same market with similar customers that generate revenue close to yours. If you own a small flower shop, for example, you could research other florists within a 10- or 20-mile radius of your location to see what their businesses have sold for in the recent past. Let’s say you found 10 other florists with an average selling price of $55,000. Then you could use $55,000 as a valuation for your business based on market comparison.
- Pro: This method may give you a quick ballpark estimate of the value of your business if sale prices of similar companies are accessible.
- Con: This method may not be as precise as using your assets, cash flow or revenue or earnings because it may be difficult to make exact comparisons with other small businesses that are privately owned. Public information about your competitors may not be readily available.
Using This Business Valuation Calculator
Whether you are preparing to sell your business, need a valuation for insurance or are just curious about what your business is currently worth, our Business Valuation Calculator provides you with an estimated value based on a calculated discount rate. A colored bar graph illustrates your discounted cash flows projected out over the next 10 years.
About Your Inputs
Using the discounted cash flow method to estimate the current value of your business, our Business Valuation Calculator collects the following inputs:
- Annual earnings before interest, taxes, depreciation and amortization (EBITDA) – How much money does your business generate each year? Basically, EBITDA measures the profitability of your business. The dollar amount that you enter should be company earnings before accounting for any of the following: interest paid on any loans or credit card accounts; the payment of federal, state and local taxes; depreciation of business assets over time (e.g., computers, transportation vehicles, machinery, etc.); and amortization, the process of gradually writing off the initial expense of a business asset (e.g., the purchase of a retail building, parking lot or major piece of equipment).
- “Excess compensation” paid to owners – The profitability of a small business often depends on the knowledge, experience and entrepreneurial skills of the owner(s). A company’s attempts to reward an owner for their unique role and efforts may lead the Internal Revenue Service (IRS) to challenge the compensation paid and view it as “excessive compensation.” Consequently, the IRS can reclassify a portion of the owner’s compensation as a dividend, which is not tax deductible by the business, rather than as wages, which are tax deductible. Enter a dollar amount for “excessive compensation” here, if applicable. (Learn more about what “reasonable compensation” means from the IRS and The CPA Journal.)
- Anticipated rate of earnings/compensation growth – At what percentage rate do you expect or project your business earnings/compensation to grow? (The next field asks you for a duration of time.) Enter a percentage figure from 0% (earnings will remain level) to 100% (earnings will double).
- Number of years earnings are expected to continue – For how many years do you anticipate your business to continue generating earnings? Enter a number between 0 and 10. By entering the maximum of 10, you assume that a cash flow of earnings will continue into perpetuity (indefinitely long duration).
- Level of business/industry/financial risk – Where does your business fall on the scale of risk? Typically, restaurants and retail (e.g., a clothing store) are considered lower risk than manufacturing (e.g., an automobile factory) and high tech (e.g., a business application software developer). The level of business/industry/financial risk you select will determine the calculated discount rate for this valuation method:
Level of Risk Calculated Discount Rate None 3.0% Low 6.5% Average 10.0% Considerable 13.5% High 17.0%
- Discount for lack of marketability – Does your business suffer from a lack of marketability (perhaps due to its small size) or exhibit strong marketability (from long-standing brand recognition, for instance)? Enter a percentage amount from -100% to 100%. A positive discount percentage (between 0% and 100%) indicates some lack of marketability, while a negative discount percentage (between -100% and 0%) indicates more favorable marketability. Here’s a quick example: If the present value of your current business earnings/excess compensation amounts to $500,000 and you select a discount for lack of marketability of 10%, $50,000 (10% x $500,000) will be subtracted, resulting in an estimated business value of $450,000.
About Your Results
Based on your inputs, our Business Valuation Calculator estimates the total value of your business based on a specific discount rate, determined by the level of business/industry/financial risk you select. A summary table displays your total future earnings/excess compensation, calculated discount rate, present value of today’s earnings/excess compensation, adjustment amount for small size/lack of marketability and estimated business value. A discounted cash flows bar graph compares your future earnings and excess compensation against today’s discounted value (shown in different colors), projected out through the next 10 years.
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