Whether you’re looking to sell your business or not, it’s always important to understand how to value your company. Small business valuation methods, however, can vary in complexity, accuracy, and acceptance amongst buyers.
Here, we’ll highlight the 3 small business valuation methods you can use to make sure you have an accurate understanding of your company’s true worth.
How to value a small business
There are a few so-called “rules of thumb” for valuing small businesses, but you’ll want to use them in conjunction with other business valuation methods to get the most accurate calculation.
One common rule of thumb: Use a multiple of percentage of annual sales.
The multiple depends on your business and requires research. Multiply the sales from the past 12 months of business by the multiple to get a quick, sales-based valuation. You can see valuation multiples by industry here.
Another rule of thumb: Use an SDE (seller’s discretionary earnings) multiplier. This varies based on industry and similarly requires research. For this valuation, you multiply your SDE by the multiplier. See multiples by sector here.
Along with your valuation method, there’s a lot of prep that goes into valuating your small business:
- Do you have all of the necessary numbers and information at your fingertips? Be sure to have an understanding of SDE, EBITDA, revenue, debt, and market capitalization.
- Do you have the right paperwork available? Business valuations will require balance sheets, tax returns, deeds, licenses, and anything else related to finances.
- Are you familiar with the state of your industry? Know your comps and the growth potential of your market.
With all of this in place, you can adopt a business valuation method.
3 methods for small business valuation
According to business acquisition platform BizBuySell, the average American business sells for 0.6 times its annual revenue.
Of course, this should only be seen as a baseline—the actual value of your company is deeply impacted by your specific situation, industry, and location.
The three methods you can use to analyze these impacts and get a true valuation of your company include comparable analysis, adjusted net assets, and discounted cash flow (DCF) analysis.
1. Comparable company analysis
Comparable company analysis, commonly shorthanded as “comps,” is a small business valuation method that evaluates a company based on the value of other companies.
Because of this commonsense approach, it is a very common and accepted form of valuing a company. Also referred to as “public market multiples,” “trading multiples,” “equity comps,” and “peer group analysis,” this method is very similar to market-based valuation and precedent transaction analysis.
Comps often focus on multiples of EBITDA, meaning Earnings Before Interest, Taxes, Depreciation, and Amortization.
EBITDA multiples are usually used to determine value for large corporations, while smaller businesses often look at multiples of Seller’s Discretionary Earnings (SDE). SDE is a company’s annual EBITDA plus the annual compensation paid to the business’s owner.
As the name suggests, comparable company analysis calculates a business’s value by comparing it to the value of comparable businesses.
Region, industry, and size are common ways businesses are grouped together. Small businesses are commonly compared based on enterprise value to sales (EV/S) and price to sales (P/S).
To value your company via comps, you should research the sale price of businesses similar in size, sales volume, and revenue. In most cases, you can get this information from quarterly and annual reports—or by paying for a market intelligence platform (though that can be pricey).
If you’re having a hard time gathering this information, an appraiser can ensure accurate comps analysis.
This video gives a solid rundown of how to carry out a comps analysis.
2. Adjusted net asset method
An assets-based valuation of a company will look similar to a balance sheet. For a slapdash “back of the envelope” value of your business, add up all your company’s assets and subtract all liabilities. This can give you a starting value, but it doesn’t take into account the wider market or future earnings.
The idea of the adjusted net asset method is to identify the fair market value of all of your assets, and subtract your liabilities (tangible and intangible).
The most difficult part of this method are the adjustments themselves. Adjustments can be made on the asset or liability side to reflect market value. For example, you can adjust for:
- Property: Whether real estate or personal, property book value is not always going to reflect its market value.
- Inventory: The speed of items sold, when they were stocked, and how they are accounted for (see LIFO vs FIFO, for example) are all levers when identifying the true market value of your inventory.
- Accounts Receivable: If your company has outlying collectibles, you can adjust based on whether those collectibles are expected to be paid in full or not.
Even if it doesn’t take into account the totality of your venture, an asset-based valuation can at least set a starting price.
Tim from MoneyWeek does a thorough job explaining the adjusted asset method here.
3. Discounted cash flow (DCF) analysis
To conduct a discounted cash flow (DCF) analysis, you must complete a complex formula that uses past data to predict future revenues for your business. The formula compares a company’s cash flow to its cost of capital.
The components of the formula are:
- Cash Flow (CF)
- Discount/Interest Rate (r)
- Period number/time period (n)
A buyer looks at a DCF analysis to understand the potential future revenue of a company in comparison with the risk involved with the business.
Because the DCF analysis formula requires an intensive forecasting model, it is the most detailed and information-intensive method available to evaluate a company.
DCF analysis can be very useful for young small businesses—a new company might have a great probability of earning profits in the future even though it runs at a present loss.
Watch Warren Buffet break down the DCF approach.
How do you value a business quickly?
The most simplistic way to find the value of a company is to look at your balance sheet and subtract your total liabilities from your assets—similar to the adjusted net assets valuation method, simply without the adjustments.
“Depending on the business, the balance sheet might show tangible and intangible assets and a variety of long-term liabilities, some of which you might be able to reduce through negotiations and invoking early-termination agreements,” writes Steve Milano in the Houston Chronicle. “If it’s a complex balance sheet, you can simply take the assets you think you can sell quickly and subtract the liabilities to determine the company’s net worth for a fast sale.”
While you’ll want to get an appraiser involved and do more financial modeling before any agreement is reached, a balance sheet can give a pretty basic sense of a company’s value in a pinch.
If you have the time, it’s important to do your company the proper justice in identifying its worth, however.
You should consider much more than just physical assets and sales numbers. The value of your business could partially derive from aspects that don’t appear on a balance sheet, like your ideas, customer base, location, and curb appeal.
Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.
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