If someone asked you how much your small business is worth, would you know the answer? If not, you are not alone. Many entrepreneurs cannot answer this question. The reason is, many variables and factors represent a company’s total value, and it can be challenging to stay on top of them. That said, conducting a business valuation is a great way to evaluate your small business’s financial health and short-term and long-term potential.
There are several business valuation methods to choose from based on your situation and the reason(s) why the valuation is needed. These methods are widely used among business owners in all industries nationwide. In this Balboa Capital blog article, you will learn all about business valuation. First, we explain what a valuation is and why you may need one. Also included are descriptions of some of the most common business valuation methods.
What is a business valuation?
Business valuation is an accurate and objective estimate of how much a business is worth. It is based on how a business has performed over a specific time frame. For example, let us say that you own a woodworking business. In that case, you would assess the current value of your business by looking at your capital, inventory, property (if applicable), and the market value of your woodworking equipment, vehicles, and other assets. You may also include your woodworking business’s year-over-year revenue and projected earnings.
Reasons a valuation is needed.
You can conduct a valuation to see how much your business is worth and to get a top-level overview of your business’s financial health. The valuation can provide you with information about the business that you might not know about. In addition to wanting an estimate of the economic value of your business, other reasons warrant a valuation.
For example, you may want to sell all or part of your business or establish a partnership with another company. Or, you might be looking to expand your operation and attract investors. A valuation can also be helpful if you need to obtain a business loan, modify partner ownership percentages, or buy out an existing partner or owner.
Common valuation methods.
Regardless of the reason(s) you need a business valuation, it is recommended that you work with an accountant, tax professional, or business appraisal professional to get the most accurate assessment. Following are some of the most common methods used by business owners.
Book value method.
The book value method is a relatively simple means of measuring your business’s tangible assets. It involves subtracting the total liabilities from total assets on the balance sheet. The resulting figure is the book value of the tangible assets you own.
For the most accurate results, you will need up-to-date balance sheets. If there are intangible assets on your balance sheet (e.g., trademarks, software, intellectual property, etc.), make sure to exclude them from the calculation.
Market value method.
The market value method can be challenging because it requires data and information about businesses similar to yours that have recently sold in your market area. For this reason, the results may be perceived as skewed, subjective, or inconclusive. However, this business valuation method should not be overlooked, particularly if you want to sell your business.
When a privately owned business or sole proprietorship in your area sells, check online to see if any sales information such as the transaction amount is available. In most cases, it will not be. So, consider hiring a business appraiser, as they might have access to databases that list the latest sales information.
The result of the market value method can be used to negotiate a higher price. For example, suppose a restaurant owner wanting to sell their establishment learns that two restaurants in the same market sold for an average price of $600,000. In that case, the $600,000 price point can be mentioned at the negotiation table.
Discounted cash flow method.
The discounted cash flow (DCF) method determines the current value of your small business’s cash flow. If your business has cyclical sales cycles, resulting in profits that you expect to be inconsistent throughout the year, the DCF method can prove to be beneficial. The “discount” in discounted cash flow refers to the risk of your business not being able to meet or exceed its profit goals.
You may need assistance from an accountant when conducting a discounted cash flow analysis. This is because various figures need to be calculated with this business valuation method, and you will need to reference your cash flow statement, discount rate (the interest rate that establishes the present value of future cash flow), and the weighted average cost of capital (WACC). Please note that the WACC can also be used as the discount rate.
Return-on-investment (ROI) method.
If you want to sell your small business, the return-on-investment (ROI) method can be used to establish its value for potential buyers. Simply put, it is a realistic estimate of how much money the potential buyer can expect to make after purchasing all or part of your business. For example, if a landscape design business owner has a selling price of $300,000 in mind, and the company had a net profit of $100,000 last year, the ROI is 33.3% ($100,000 ÷ $300,000 x 100).
The ROI method can also be used if you are selling a specific percentage of your business. For example, let us say you want $150,000 for 20% of your business. In that case, you would divide $150,000 x 20%. In this scenario, you are valuing your business at $750,000. Again, remember to present realistic returns to potential buyers and investors; otherwise, they might not be interested in moving forward.
Becoming familiar with the various business valuation methods can help you better understand which one(s) are best for you. In addition, you will be better able to establish what your business is worth. Finally, as we mentioned earlier, it is a good idea to consult with an accountant, tax professional, or business appraiser. These individuals can help you select the correct market value approach and ensure that everything is done correctly.
The information in this blog post has been prepared for informational purposes only. It is not intended to provide and should not be relied on for tax, legal, investment, or accounting advice. You should consult with your accountant, lawyer, or tax advisor before making any business decisions or moving forward with business funding.