Small Business Valuation 101 – Essential Business Valuation Basics for Calculating Value
Small Business Valuation 101 explains estimating your business value or worth.
Business valuation at the rule of thumb level is very simple like the summary shown immediately below. Yet formulating an opinion of value can be endlessly complex. Part of the complexity comes because business valuation is forward looking. Likely foreseeable cash flows, not past cash flows are the basis of the value. That alone brings many assumptions into play and room for disagreement.
So here it is – Business Valuation at it’s simplest:
The subject company or company being valued is compared to something else to determine value. For instance:
- Under the asset approach the comparison is the cumulative total asset value less total liability value. (Add up the current “market” value of all your assets. Subtract all your debts. What is left is the business value under the asset method. For instance, Cash is $100,000 plus Trucks $50,000 plus Inventory of $200,000 equals $350,000 less accounts payable and debt of $100,000 means the business value using the asset approach would be $250,000.
- Under the market approach you are comparing market sale comparables to the subject company. Find “comparable companies” that sold. Determine how much they sold for compared to their “cash flows”. This ratio is called a multiplier. Multiply that multiplier times your company cash flow to get a value. For example Joe’s garage sold for $300,000. Joe’s garage had cash flow of $150,000. The multiplier is 2 estimated as $300,000/$150,000. Your garage has cash flow of $125,000. Your garage’s indication of value is $250,000 estimated as $125,000 * 2.
- Under the income approach it is comparing all investment opportunities to the subject company. One way to do this is to come up with a required return to obtain an investment in the subject company based on risk. Divide your cash flow by the required return. For example Cleaning Supply Distributor has cash flow of $500,000. The capitalization rate is estimated at 20%. $500,000/.2=$2,500,000.
That’s it at the simplest level. But life and businesses are not so simple. In fact each of these simple steps above combines many other steps, research, assumptions etc. Therefore, business valuation is not really quite so simple either. What is shown above is an useful place to start but certainly not the place to stop. Keep reading if you want to know more.
Three Main Valuation Approaches
The Asset Approach, the Market Approach, and the Income Approach.
One of the most important decisions a valuation analyst makes is which approach and then which method under the approach to use. Methods are subsets of an approach. Methods under an approach often share key elements of the approach but have different details and can result in very different values for the business.
Asset Approaches
The asset approach compares the value of the assets less the value of the liabilities (debts) of the company and the difference is the company value. The formula is Assets – Liabilities = Value. The assets and liabilities are often valued to different standards. A few of these standards are; book value defined as what it is on the accounting books, market value or what the asset would cost from a dealer, or various liquidation values depending on how fast the assets need to be sold. For small and very small businesses this analysis tends to leave off the value of intangible assets and is often used for liquidating companies. Going concerns or companies expected to continue operations use the next two approaches.
Market Approaches
The Market Approach compares market prices, either public stock prices or sales of comparable private companies to the company being valued. The underlying principal is Cash Flow times a Multiplier which is derived from the comparable data equals Value.
Cash flow for the future is estimated from past adjusted cash flows. Normalization adjustments are made so the cash flow is an apples to apples comparison with the comparables’ cash flows used to determine the multiplier.
The multiplier is calculated as Sales price / cash flow. For example a sales price of $1,000,000 / a cash flow of $350,000 = a multiplier of 2.85. This ratio is called a multiplier. Each comparable transaction will have a different multiplier. This multiplier is further adjusted based on similarities and differences between the comparables and the company being valued. The final selected multiplier is multiplied by the subject company estimated cash flow to calculate a value. Cash flows typically used include revenues, EBITDA (earnings before interest, taxes, depreciation, and amortization) and SDE (seller’s discretionary earnings or EBITDA + all the ways one owner makes money from the business). The analyses for both cash flow and selecting the correct multiplier can become quite multifaceted.
Income Approaches
The Income Approach estimates a rate of financial return called a discount rate that investors will require in order to invest in the subject company. In the simplest shorthand the normalized future cash flows are divided by the discount rate to calculate value. These investors are generally assumed to not be owner operators but true investors.
Data about required returns for investors is used to “build up” a discount rate which is in effect a required rate of return for investors. For instance Federal treasury bills are considered the risk free rate, then the increase in required return for large company stocks is added and so on until a risk rate equal to the risk in the subject company is calculated. Again, this is an estimate of the return that will be required by an investor to invest in the company.
Under the discounted cash flow method each years future cash flows are forecast, discounted, present valued and added together to perpetuity. Because perpetuity would be hard to calculate this usually includes a terminal value calculation to address the period between the end of the forecast and perpetuity. This terminal value is added to the value from the discrete years.
Under the capitalization of earnings approach historic cash flows are reviewed and adjusted to reflect likely future cash flows. Then the discount rate is reduced by a long term growth rate to develop a capitalization rate. Finally the next year’s cash flow is divided by the capitalization rate to determine the value.
Please note: this article is a simplified overview, estimating and normalizing cash flows and estimating the discount and capitalization rates quickly becomes quite complex.
Two other major factors may provide a huge swing in value found: determining what interest is being valued and deciding the standard of value
Interest being valued – Often the value of the entire business is being valued. This is the enterprise value which includes both long term interest bearing debt and stock or equity in the capital structure. If the debt is subtracted or otherwise adjusted for the stock or equity value is calculated. Those are two interests. Discounts can be used to adjust for variances between the comparable set and the subject company. More often discounts are used to adjust for differences between majority control owners of a company and minority non-control shares in private companies.
Minority non-control shareholders are shareholders who cannot directly influence company policy and procedures. Because these shareholders are “along for the ride” there tends to be no market to sell these shares. Therefore under a fair market value standard of value (essentially a transaction price) they have far less value than the majority or control shareholders stock. Where a lack of control minority interest is being valued discounts for lack of control and discounts for lack of marketability (DLOM) are estimated and used to reduce the enterprise value found. Stock options, debt, convertible debt are all interests in businesses that can also be valued. Finally goodwill and personal goodwill are intangible interests that may be valued. Valuing each interest involves additional methods and comparisons.
Standard of Value – this is shorthand for who is the buyer and who is the seller. For instance a race car will have very different values to a family looking for a safe car and a race car driver.
Fair Market Value – “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Rev. Ruling 59-60.
Basically this is a typical buyer and a typical seller making a market. The buyer and seller are hypothetical not the actual parties.
Fair Value – is the same as the fair market value of 100% equity ownership in the enterprise divided prorata based on percentage ownership. There are no discounts for minority interest or discounts for lack of marketability for lack of control shareholders. This is frequently used in state statutes to protect minority shareholders.
Synergistic Value – This is the value to a buyer where the buyer can make more money from the acquired company than the acquired company could on its own. For instance two delivery companies with half empty trucks going on the same routes. Surely if one acquired the other the successor would be more efficient and profitable. Therefore the target company can be worth more to the synergistic buyer than other buyers.
Investment Value – this is a market value where the buyer and seller are known and the valuator attempts to use actual revenues and expenses from the two companies. Remember fair market value is NOT the actual buyer and seller but a representative typical buyer and seller.
To Summarize
The subject company or company being valued future cash flows are estimated and is compared to a comparison set to determine value.
- Under the asset method it is the cumulative total asset value less total liability value.
- Under the market method it is comparing market sale comparables to the subject company.
- Under the income method it is comparing all investment opportunities to the subject company.
These methods are used to determine the enterprise value. This enterprise value will be influenced by the standard of value or definition of who the buyer and seller are. Finally discounts may be applied for minority or other interests. The results are an indication of value.
Greg Caruso J.D., C.P.A., C.V.A. is the author of “The Art of Business Valuations: Accurately Valuing a Small Business” (to be published by Wiley in late 2020), an easy to understand yet technical guide about on valuing small (under $10 million revenues) and very small (under $5 million revenues) businesses. In addition, sample reports, checklists and working Excel files of many calculations are provided as resources
Greg is a Partner at Harvest Business Advisors where he has valued and brokered hundreds of small and mid-sized businesses. As Editor-In-Chief of “Around the Valuation World”, a monthly webinar for the National Association of Certified Valuators and Analysts (NACVA), he is in the forefront of current business valuation practices.
Reserve your copy of “The Art of Business Valuations: Accurately Valuing a Small Business” today.
