Are you building a business with the goal of selling it down the road? You’re not alone — this is a common strategy among entrepreneurs. Before you can list your company for sale, however, you have to know how much it’s worth. That’s where business valuation comes in. This process helps you put a dollar amount on your company so you can negotiate a fair sale.
Valuing Your Business
Before you start a business valuation, it’s important to note that the process is not a perfect science. No matter what valuation method you choose, you can plan on making predictions and judgment calls about everything from risk to sales projections. This simply means that there’s no “correct” value for your company — all you can do is stick to the facts and be realistic.
To get the most accurate number, it’s important to base your assumptions on facts. Business valuations work on the ‘garbage in, garbage out’ principle, which means that unrealistic estimates won’t actually make your business more valuable. In fact, the more you can back up your valuations with solid numbers and facts, the more likely a buyer is to accept your price when you’re selling your business.
Valuation Methods: How to Value Your Business
When you decide to value your business, you can choose from a variety of approaches. The two most common options are asset-based valuations and income-based valuations.
An asset-based valuation calculates out how much your company is worth by subtracting your liabilities (the money you owe) from your assets (the things of value that you own). The simplest asset-based method is called the liquidation method. When you use this approach, you measure the fair market value of your company’s assets. What does that mean? It’s the amount of money you could get if you immediately sold all your assets on the open market. From that amount, you’d settle all your debts. The remaining money is your company’s value. The liquidation method may be best for you if your business has erratic or negative earnings and cash flow.
The tricky part of this method is usually figuring out the fair market value of your assets. In many cases, you can estimate this amount based on public listings of similar assets. If you have vehicles, for example, you could see how much vehicles of the same make, year, and condition are selling for. The more liquid an asset is — how easily you could sell it for cash — the easier it is to value. If you need to value intangible assets, such as trademarks and customer lists, the process gets more difficult. In that case, you probably need to enlist a valuation professional to figure out a fair value.
There are two major income-based valuation methods: the discounted cash flows method and the capitalized earnings method. These methods are similar in that they both estimate the amount of money your company might earn over its lifetime. However, the way you apply these methods is significantly different.
Discounted Cash Flows (DCF) Method
A DCF valuation figures out how much your company is worth now based on projected future cash flows. To start, you need to make a cash flow forecast. It can help to analyze your company’s cash flow history — that way, you can identify trends that allow you to predict future cash flows with greater accuracy. When should you use the DCF method? Usually, it’s most appropriate when your cash flows are positive and they follow a trend. You can also use it when you can forecast cash flow accurately enough to satisfy your stakeholders.
In order to make cash flows realistic, you should remove any one-time expenses that are outside your normal business operations. This could include the money you pay to restructure the company, hire lawyers during lawsuits, or recover losses from natural disasters. Once you remove these items, you normalize your cash flow. Keep in mind that your cash flow doesn’t include depreciation of your assets. To account for this, you can come up with an amount of money that you can expect to spend each year on replacing and maintaining equipment. This is called the sustaining cash flow.
Usually, it’s a good idea to forecast detailed cash flows for a five-year period. If you forecast any further into the future, you run into too much uncertainty. As you estimate cash flow beyond five years, you use a flat rate called the terminal rate. It’s important to use a conservative estimate for your terminal rate.
Once you have a cash flow forecast, you need to discount it. This helps you adjust for the time value of money. After all, as the old the adage goes, a dollar today is worth more than a dollar tomorrow. Therefore, in order to calculate the value of those cash flows today, discount your cash flows by applying this formula.
Capitalized Earnings Method
The capitalized earnings method has a simpler calculation than the DCF. This means that it’s easier to value your company, but the final number might be less accurate. The capitalized earnings method is most appropriate when:
- You have positive earnings
- You can estimate an accurate growth rate
To calculate your capitalized earnings valuation, subtract your operating expenses from your net operating income (NOI), or revenue. Before you do so, you should normalize your NOI by removing non-cash items such as depreciation and adding a sustaining cash flow amount. The result is called your adjusted NOI.
At this point, you can simply go forward with your adjusted NOI. Do you want a more accurate number? Calculate the adjusted NOI for two or three past years. Then, take the average of those years. (It’s a good idea to use years with adjusted NOI amounts that are representative of your company’s normal operations.)
Once you’ve figured out a reasonable adjusted NOI, you can perform the ‘capitalization’ that gives this method its name. To do so, you apply a multiplier to the adjusted NOI. You calculate this multiplier by adding your Weighted Average Cost of Capital (WACC) and your company’s expected growth rate. Then, take the reciprocal of the result to get your multiplier. You need the growth rate because you’re not accounting for growth anywhere else in the calculation.
Imagine that your company’s WACC is 8%. You expect an average growth rate of 2% per year in perpetuity. That means that your capitalization rate would be 10%. To get the reciprocal of this amount is, divide 1 / 0.1 (10 per cent) to get a multiplier of 10. To get the value of your business, multiply your adjusted NOI by your multiplier of 10.
Not sure which valuation method to use? You might want to calculate your company’s value using two or more methods. Then, you can take the average of those values to get a more realistic number. Business valuations can get complicated, especially if you have a complex business. If you’re not sure where to start, it’s a good idea to hire a Chartered Business Valuator to help. This allows you to enter sales negotiations with a realistic valuation — and get a fair sale price for your business.
Want to make the valuation process easier in the future? Start tracking your finances and cash flow now. Improve your cash flow with invoices, payments and expense tracking. See how much cash you have on hand with QuickBooks.