How-To Guide: Business Valuation – Part 1

Value vs Price

By Steve Whitehill

Before you make the decision to buy or sell a business, the first step you need to take is to determine its value. Valuation, like beauty, is in the eyes of the beholder. That is because there are many different ways to value a business – along with pretty much anything. To do so, you must calculate exactly what the business is worth. Following are some common ways to do so. Each has something to be said for it:

  • Asset value – Tally up the value of the assets and that is what it is worth. But what is the value of a used vacuum cleaner? Or what is the value of a customers list or inventory for that matter.
  • Cost approach – The cost approach is a typically a real estate valuation method. It estimates what you should pay for a property (or business) or the cost to recreate an equivalent building (or business).
  • Discounted cash-flow analysis – Businesses have, and I am going to use the word, earnings in a very broad meaning as opposed to income or profit. These earnings or profit, while varying over time, go on for the life of the business (think of it as apartment rent which continues over the life of the apartment). So the question becomes what is these series of payments worth in a lump sum today? To determine that we need to determine several things. First is what is the correct interest rate? Remember interest rates vary over time and they go up and down. Next is what is the earnings stream? Does it remain constant, does it go up, or does it go down? What is the growth rate and how consistent is it? These are some of the questions and issues you have to think about.
  • Valuation based on revenue – Based on the business’s annual revenue (for our purposes) from sales, an industry multiple is applied to determine the value of the business. One key problem with this approach is not all business within a sector or industry have an equal efficiency (read profitability). For example, which would you rather buy: a pizza restaurant that makes 15% or one that makes 25% of revenue.
  • Valuation based on earnings – not unlike valuation based on revenue, this approach bases valuation on earning or profitability of the company. The question becomes what is profit or earnings. Is it what you have on the income statement (profit & loss) or is it what is on the company’s tax return or is it something else? What we use is a measure of profitability called Owner Benefit or industry types like to call seller’s discretionary earnings or SDE. What is the Seller Discretionary Earnings (SDE) for my business? The SDE is a measure of how the owner benefits financially from their business in a given year. We then take SDE an apply an industry standard multiple which is derived from a comparison of industry sales.

So, which is the best approach? Each of the above valuation methods has its strengths and weaknesses. Generally speaking, for main street and lower middle market business we use the valuation based on earning. The critical issues are to determine SDE and the correct multiplier.

We have developed a calculator for business valuation to give you a general idea of what your business might be worth. You can use our calculator by clicking here. In fact, we have two available for your use. One is simple and requires a minimal set of information and the other is more advanced and requires more thought and information. Both are at no cost to you. While we do this process manually as a rule, we follow the same process and we use these calculators as a first draft or to double check before presenting our opinion of value to our clients.

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