When determining how to value your business, there are many business valuation methods to use. But for now, let’s focus on these three basic ones to derive a business value and learn how they help you determine what your business will sell for.
How to Value Your Business
There are three primary business valuations to be familiar with:
1. Multiple of Earnings
2. Comparable Companies
3. Discounted Cash Flow
Business Valuation Methods
How to Value Your Business: Multiple of Earnings Valuation
The multiple of earnings also known as the “MOE” valuation is widely used and usually the first valuation metric a buyer will consider. This is due to the fact that it can be easily calculated and does not take considerable analysis to figure out. There are two basic numbers you will need to find the value: (1) net earnings for the previous year; and (2) a multiplier. Then, you simply multiply the two numbers together and there you have your business value.
Let’s look at an example:
A business has a net income of $1 million
The average multiple for the industry and company size is 3x
After simply multiplication, the business would receive a valuation of $3 million
Note that there is a multitude of additional factors that come into play here but for ease of understanding this example was kept simple. First, the net income is always adjusted. Business brokers and M&A advisors will find one-time expenses, non-recurring expenses, and any personal expenses that ownership is running through the business and add it back to the net income ultimately increasing the valuation. Second, the multiple is very important to accurately define as different industries use different multiples. For example, service-based businesses may sell at 2 – 4 times net income. Whereas software companies can be valued at 8 – 10x times revenue. We will cover this more in future training on our blog.
How to Value Your Business: Comparable Company Valuation
The next important valuation methodology is looking at comparable company valuation. This is similar to selling your home when your real estate agents will look at what other properties in your neighborhood are priced at and selling for. The same is true for your business. An advisor will analyze a set of companies in the same industry. Specifically, businesses with a similar revenue/net income size, age, and location as yours. Then determine your business value using those comparable businesses as a reference. This method is harder for business owners to determine unless they know what one of their competitors recently sold for. In terms of finding your business value, this is an extremely important factor that investors will consider before putting in an offer.
How to Value Your Business: Discounted Cash Flow Valuation
Discounted Cash Flow, also known as the “DCF” valuation, is the other broadly used methodology to determine business value. In short, it is calculated by projecting out future cash flow for the business and discounting it to present value. This method requires the most amount of technical analysis. Advisors will spend a lot of time attempting to accurately determine what the future will look like for the business and industry as a whole. This valuation methodology can sometimes come under scrutiny for the assumptions that are made. This is due to the fact that no one can see the future. However, it is important for investors to project the future performance of the business so they can determine what their return on investment will be.
Why is my business valuation important?
There are many reasons for entrepreneurs to know the price tag of their business. Maybe you need to get a business loan, take on investors to raise capital, buy/sell agreements, tax purposes, and at some point, every business owner will have to begin thinking about an exit strategy.
In any case, an accurate business valuation is crucial to protect the hard work and sweat equity that owners create. In order to best position yourself to maximize your value, a strong business valuation will help hold your value when investors try to knock you down on price.
The 3 valuation methodologies above are starting points for negotiation, but ultimately the market will dictate the price of your business based on what an investor is willing to pay.