What Is a Business Valuation Formula?
Every business has a certain amount of monetary value. No matter whether it’s a mom-and-pop store or a Fortune 500 enterprise, a business can be thought of in terms of the dollar amount it is worth.
How do you determine that amount? There are several approaches.
KPMG Advisory reports that in 2021, the mergers and acquisitions (M&A) market reached $5.1 trillion in transactions, which is only slated to grow in 2022. That means there’s an enormous amount of activity in buying and selling businesses, and several different valuation methods are being used in those exchanges.
It’s important for anyone looking to buy or sell a business to understand some of those methods, and which ones are best applied to your particular case.
Working with a broker is usually the best way forward for getting a reliable valuation — whether it’s your own company that you’re looking to exit or one you’re seeking to acquire as an investor.
The Basics Of Understanding Business Value
The most elementary way to value a business is to subtract its liabilities from its assets. Assets in this case are resources that a business owns, including cash and whatever can be turned into cash. Liabilities are debts that the business takes on, such as a line of credit, or a mortgage.
Using the difference between assets and liabilities is considered an asset-based approach to valuing a business. It’s a simple, quick method. However, the figure you arrive at from this calculation is only the first step.
Brokers may choose to apply several other valuation methods and formulas to the raw business value to determine a range of viable list prices.
Commonly-Used Small Business Valuation Formula Multiples
Two formulas commonly used for valuation, the EBITDA, and SDE, can determine a range of prices for a business based on current earnings and the likelihood of maintaining the same level of income in the future.
Discounted cash flow (DCF) is another method that projects business value based on income, but using it is more complicated.
EBITDA, or “earnings before interest, taxes, depreciation, and amortization,” adds back some expenses to the business earnings total, as suggested by the name.
Seller’s Discretionary Earnings (SDE)
The SDE, or “seller’s discretionary earnings” balance, calculates a business’s value based on the earnings that the owner directly generates from it. The formula for SDE is:
(Pre-tax, pre-interest earnings) + (such as travel, vehicles, and other transactions that are listed as business expenses) = SDE
SDE is often used for smaller businesses run by a sole proprietor. It adds back business expenses with some degree of personal benefit to the owner. The formula shows potential buyers a rough estimate of what they might earn, should they become the owner-operator and work under similar conditions as the seller.
SDE and EBITDA are both calculated with a numerical multiple to determine what a business might sell for. For example, if Company A has an EBITDA of $1 million and a multiple of 6 is applied, a possible list price is $6 million. Company B with an SDE of $400,000 and a multiple of 2 might be listed for $800,000.
Discounted Cash Flow (DCF)
Instead of using revenue as the basis for valuations, assessing discounted cash flow (DCF) involves looking at the current cash flow of a business and basing projections of future income on it.
In a DCF analysis, brokers try to determine the current value of an investment based on the ROI expected in the coming years. The calculation uses a “discount rate” that assumes the money invested now is worth more than the same dollar amount in the future. The level of risk in the industry and the real value of all business assets are also considered.
Since this method can involve many factors unique to both the business and the market, a broker or experienced business analyst may be the best person to determine whether to use DCF and conduct the actual analysis.
Other Factors That Raise Business Value
Besides the raw numbers, many other factors can affect the fair market value of a business (that is, the price that is reasonably presented to sellers on the market).
The variables can substantially raise or lower the amount of risk an investor is taking on by purchasing the business.
These factors include:
Hard vs. Soft Assets
The number and quality of assets owned by a business can make a huge difference in its value to potential future owners.
“Hard” assets like equipment, real estate, and patented technologies often figure into the value. “Soft” or intangible assets, such as customer lists, employees, and long-term vendor relationships can represent a high value for buyers if they’re fully transferred over in the sale.
Marketing, if it’s done well, will bring a consistent stream of new customers and prospects into a business.
A combination of both offline and online methods can work well, but it’s especially important to leverage modern digital methods — such as a blog, search engine optimization (SEO), social media, and pay-per-click (PPC) advertising — to stay competitive in almost every industry.
Cash Flow Stability
The ability to maintain positive cash flow as much as possible is a sign of a healthy business. Any losses or periods of negative cash flow should be counteracted by an increase in sales, and a business should have a working plan for weathering such downturns.
Based on sales performance, a company should be able to make confident projections of revenue for the near future. Implementing good sales and marketing strategies, and refining them over time, can result in even better projections.
Entrepreneurs that can forecast a healthy business income, and back it up with growing sales numbers, are at an advantage when looking to sell their business at a higher price.
No matter what valuation methods are used and what behind-the-scenes factors that will influence the sales price of a business, getting a professional valuation from a qualified broker will ensure you’re standing on solid ground when you begin negotiations.
Get A Professional Valuation From Raincatcher
Business valuation formulas are easy to plug numbers into. However, this alone often doesn’t represent the real value of a business, nor may it give you an accurate idea of what buyers are willing to pay.
That’s why it makes sense to talk with a professional broker, like the professionals at Raincatcher.
Raincatcher’s brokers understand all the standard valuation formulas and routinely utilize them when valuing businesses for both buyers and sellers. We also have a proprietary process for analyzing a business, including operations, financial statements, and other variables, to make sure our valuations are a true reflection of what a business is worth.
Valuation goes deeper than formulas, and it’s important to get it right. Contact Raincatcher for a professional valuation from an experienced broker today.