The Different Methods for Valuing Your Business

Perhaps the most important exercise of selling a business is figuring out a proper valuation for it. This valuation will serve as the measuring stick for all parties involved.

It will give you, as the seller, a goal for what the final sales price of your business will be. It will allow you to forecast how much money you’ll get after all your financial obligations are met. It allows you to plan for the tax impact of the sale.

A proper valuation will also significantly impact how negotiations go. If your business valuation is too high, you’re likely to set your sales price too high. This could then lead to you not receiving much interest from buyers.

If your business valuation is too low you’re likely to set your sales price too low. This, of course, could lead to you receiving less money than you should in return.

The goal of any business valuation is to land on a fair market value for the business. Regardless of what you may think your business is worth, this objective valuation will help determine the price at which your business could change hands on the open market.

By definition, this will assume the buyer is under no obligation to buy, and you as the seller are under no obligation to sell. In that way, you can arrive at a fair market value.

There are four main approaches to valuing a business, each that has a slightly different way of landing on the final value.

Earnings Capitalization Approach

This approach will seek to figure out what your company should be earning, on average. The theory behind it is the best indicator of a company’s value is its ability to generate profit.

To do this approach, you’ll take the average annual earnings of your company over the last three years. Future earnings of the company will be based on past earnings.

From the balance sheet, you’ll need to remove items such as discretionary expenses, utilities and owner’s health insurance. This way, you’ll be coming to an actual number for the average annual earnings of the business with nothing else included. This means anything that is out of the ordinary, not recurring and not necessary for operations will be taken out of the equation.

Underlying Assets Plus Goodwill Approach

This approach will seek to figure out which assets are needed to value the business. It starts with the net equity of the business, which is the book value of all assets minus the debt.

The book value is important because it’s what you want to allocate when you sell your business, because it’s tax-free money. Adjustments that need to be made are done on the balance sheet.

It’s important at this point that you list all assets that are not part of the deal — if there are any. This will let the buyer have a good idea of what they are actually acquiring and what they aren’t. It will also factor into the final valuation.

Next, you’ll factor in any goodwill calculations to come up with a combined value with the assets.

Cash Flow/Leveraged Debt Approach

This approach will determine a value of a business based on the normal free cash available from operations after current interest expense is deducted.

First, look at what your annual cash flow is. At times, you may be producing more cash than actual earnings. So, look at the average annual cash flow in the same manner as earnings.

You then divide this number by the cap rate to get a single number. The next step is to do the discounted calculation to get the future value of the company, and then average those two values to get one final valuation.

Comparables/Market Approach

The challenge with this approach is that no two businesses are the same. What you’ll seek to do here is look at the value of a comparable company as it relates to its net sales.

Another aspect of this approach is looking at EBITDA, or earnings before interest, taxes, depreciation and amortization. Then, what multiple of EBITDA can your company use for its valuation? The best way to do this is to see the industry standard for your particular business, as it can vary from one industry to the next.

This approach will basically be setting the value of your business as its net sales multiplied by a rate that’s acceptable in your industry. If, for example, your average net sales are $1 million, and your industry’s acceptable multiple is 2.5, then your business’ value using this approach would be $2.5 million.

How to Bring it All Together

The best way to come to a fair market value of your business is to use all four of these approaches. Then, decide which of these approaches will be best for your business in your industry, and then give a weight to each.

You may think three of these approaches would work well, with all three holding equal weight. In that case, you would total the valuation from all three approaches and divide by three to get to your final valuation.

This would give you the fair market value of your business if someone would come in and purchase the business today.

Keep in mind that business valuation is an exercise that produces a fair market value for your business. It does not necessarily mean that’s what you’ll get in a final sale.

It also doesn’t take into consideration any liabilities or taxes you may still owe once the business is sold. It’s simply an objective financial review that will give you and buyers a fair measuring stick for where to start negotiations.

 

Sunbelt Business Brokers of South Florida can help you prepare to sell your business in South Florida, guiding you from listing to closing.  If you’re considering selling your business, get in touch with us today for a confidential, no obligation conversation.

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