Business Valuations
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Below are four common business valuation methods and the pros and cons of each:
01.
Book Value (Asset-Based Method)
This method considers your assets and liabilities — the accounting figures recorded on the books. The formula is quite simple: business value equals assets minus liabilities. Your business assets include anything that has value that can be converted to cash, like real estate, equipment or inventory. Liabilities include business debts, like a commercial mortgage or bank loan taken out to purchase capital equipment. If your assets are $100,000, and your liabilities are $30,000, then your business valuation would come out to $70,000.
Pro
This method may be preferred when others result in giving you a lower business valuation.
Con
This method may not account for important intangible aspects of your business — such as your long-standing reputation in the community and loyal customer base — which could boost the value of your business in the eyes of potential buyers or investors.
02.
Discounted Cash Flow
This method of valuation focuses on the future performance of your business rather than historical data. If your cash flows are consistent and predictable, your business may be more likely to appraise at a higher value. This method estimates the cash flow your business is projected to produce into perpetuity and then discounts this back into current dollars (called net present value or NPV), while also accounting for the level of financial risk indicated by your business or industry. For example, a high-tech software business is usually considered higher risk than a retail shoe store. Our Business Valuation Calculator uses the discounted cash flow method to estimate the value of your business.
Pro
Many business owners prefer this method of valuation because it focuses exclusively on cash flow, which is often viewed as an influential factor in determining the value of a business.
Con
This method is based on numerous estimates and projections of cash flow into the future, and if those figures are off base or unrealistic, your business value may be overinflated or underestimated.
03.
Revenue/Earnings
This method takes your business’s revenue (gross income) or earnings (net profit after all business expenses are paid) and uses an industry multiplier to come up with a value. If your industry standard multiple is five times sales, and your sales revenue last year was $80,000, then your business would be valued at $400,000 using this method.
An alternate version of this method examines your current earnings, makes projections about your future earnings and uses a multiple to arrive at a business valuation. The measure of earnings can be either EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization). (This McKinsey & Company report, which examines S&P 500 companies, illustrates the variability of multiples within different industry sectors.)
Pro
This method offers you a relatively easy and straightforward way to establish a rough estimate of the value of your business.
Con
Because this method involves making projections about the future revenue or earnings of your business — which may likely fluctuate for a variety of reasons in the coming years — it may lack precision in its estimating approach. For instance, a national recession may create a slump in sales while the closing of a competitor near you could give your business a boost.
04.
Market Comparison
A fourth method of evaluation compares businesses in the same market with similar customers that generate revenue close to yours. If you own a small flower shop, for example, you could research other florists within a 10- or 20-mile radius of your location to see what their businesses have sold for in the recent past. Let’s say you found 10 other florists with an average selling price of $55,000. Then you could use $55,000 as a valuation for your business based on market comparison.
Pro
This method may give you a quick ballpark estimate of the value of your business if sale prices of similar companies are accessible
Con
This method may not be as precise as using your assets, cash flow or revenue or earnings because it may be difficult to make exact comparisons with other small businesses that are privately owned. Public information about your competitors may not be readily available.
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