While it can be relatively simple to value a publicly traded company, there is so much confusion associated with how a non-publicly traded company is valued. In this article, I want to help clear up any confusion and help outline the well-tested and well-vetted process of how all businesses are assessed.
Just to be clear, this is 100% focused on valuing your company when you want to SELL. The reason I make this clarification is that there are many reasons why businesses are valued and based on what the reason is the valuation can be drastically different. This fact is a crazy reality, but it is a fact of business valuations.
99% of all privately owned businesses are valued for the purpose of selling and we only have a hand full of methods that are customarily utilized. There are three primary acceptable business valuation methods. One may be more suitable than another, depending on the type of business being valued, including its industry, size, and circumstances of sell.
This approach is often my “go-to” since it is the least subjective and based more on facts. The market approach is utilized when you have a number of similar businesses in the same industry that have recently sold and can serve as comparable transactions. A comparable transaction is when you can locate businesses that have recently sold in your industry with your level of revenue, profit, and assets, an “apples to apples” comparison so to speak.
One example would be a Service Magic Franchise. There are a variety of Service Magic Franchise locations that offer comparable sales. This type of comparable information provides the confidence to place a high value on the market approach.
Similarly, when selling an accounting practice it is very common to find a high number of comparable CPA’s practices that have sold primarily based on “revenue to value.” These again would allow us to be confident that the Market Approach truly reflects the actual value of this business (based on price based on revenue).
In the end, the importance that you place on an approach comes down to confidence. The more confident that you are that the value is based on facts makes it more viable for a ready willing and able buyer to have confidence and move forward to purchase your business.
It is crucial when comparing your company to others that have sold that you objectively compare the two. This is why having a professional database and experience is necessary. The following areas are crucial to accurately your company to another. The items you must compare should include revenue, SDE (cash flow, profit) asset value, geographic location, etc. Two companies may both be in the service industry; however, if one is a large company in New York and the other a small service company in Texas, comparing the two would not be sufficiently relevant. It is also crucial to analyze the correct financial data. For example, one company may be listing the financials as TTM (trailing twelve months) or even as the projection of the business that was sold.
The income approach is based on the principle of the future expectation of the businesses revenue and/or profit. In simple terms, this approach calculates the value of the business based on the future financial benefit combined with the level of risk that one could expect from that business. Meaning, how likely is the revenue to continue in the future.
The income approach calculates the value by projecting out the future economic benefit (cash flow) and discounting it back to the present time using a discount rate. The discount rate is specific to the risk of the industry and the business being valued.
Discounted Cash Flow (DCF): When you perform the calculation that we outlined above the new “SDE” or “profit” is called “DCF” (Discounted Cash Flow). While the calculations are complex, the purpose of DCF in this approach is merely to estimate the money a buyer would receive from purchasing the business, adjusted for the time value of money.
The income approach is most likely always going to be considered and heavily weighted when working with a quality business broker and business appraiser.
In simple terms, the asset approach is rarely used if you are valuing a business with current revenue and operations. The asset approach is only considered if the company is more valuable if liquidated for its assets than it would be if it continued to operate for cash flow or profit. Examples would be jewelry stores, larger equipment rental companies or manufacturing businesses with limited to no cash flow
Fixed assets are typically taken at the fair market value or replacement value. This value is determined by establishing the cost to replace the asset at its current location and condition today. The replacement value also takes into consideration what assets are currently being used and which are obsolete.
Many times banking institutions are looking at book value of the assets. The reason why we do not take this number when valuing a business is that the book value (the value that you have on your balance sheet) may not reflect the actual value of the assets of the company.
Replacement value method is the more refined way of calculating the value of the company; however, it comes with the drawback of incorrect estimation.
While inventory and Accounts Receivables both are considered an asset of the business, some adjustments may need to be made. These adjustments are made for non-collectible A/R or obsolete inventory.
If liabilities are included, they are also typically subtracted from the replacement value of the assets. These liabilities should be updated to the date of the valuation.
When it comes time to sell your business, it’s crucial that you set your personal feelings aside to perform an accurate business valuation and establish a realistic and competitive selling price. You’ll need to objectively analyze your business, study the current market and consider employing the expertise of a professional business broker/appraiser.
We also have articles on our blog that break down specific business types that take these principles and apply them to each industry, no matter if you desire to sell a machine shop, oil and gas service company or distribution company. Contact Sigma today if you’re thinking of selling your business!