Valuing a Small Business
The Art and Science of Business Valuation
Whether you’re a seller coming up with an asking price or a buyer making an offer, valuing a small business is often the most important part of the deal. Unfortunately, the question of how to go about valuing your business has a complicated answer. Much like a piece of art, the value is often in the eye of the beholder. Both the buyer and the seller have a wide range of variables to consider:
- Objective for the business
- Acceptable levels of risk and reward
- Differing levels of experience, expertise, etc.
- Reasons for selling
- Emotional connection to the business
- View of the business moving forward
Methods for Valuing a Small Business
While there isn’t one “correct” choice, there are a few generally accepted methods used when valuing a small business. Savvy buyers and sellers will consider all of them. These methods include:
- For-sale multiples
- Comparable transaction multiples
- Discounted cash flow analysis
Each of these options has its benefits and drawbacks. Your first step is choosing which of these options best suits you. It’s a common industry practice to come up with a range of values using various methods and then to compare them against one other. By aggregating these methods for valuing a small business, you hope to end up with a good, fair price.
Before we go into the details, let’s take a moment to talk about the concept of multiples. At its most basic level, a multiple is simply one financial metric divided by another. The most common one is the P/E ratio, or price-to-earnings ratio. This is simply the price of a business divided by its earnings. For our purposes, we are trying to find the price by taking a metric, for example earnings, and multiplying it by a number to arrive at the price. The tricky part is what number to use, which is what this article will talk about in more depth.
To learn more about multiples, here’s an excellent discussion on Investopedia.com.
Private businesses don’t often have similar publicly traded companies with which to compare themselves. In that case, the listing prices of similar private companies can shed some light on what other sellers think their businesses are worth. While this method can be a good reflection of the current market, the main drawback is that it only reflects what other sellers are asking. Since this doesn’t take into account what buyers are actually paying, sellers should manage their expectations accordingly.
To calculate a valuation based on for-sale multiples, you need to answer two questions:
- What business metric do I use?
- How do I determine the multiple to apply to it?
While there are several to choose from, the most common multiples used in valuing a small business are:
- Price / Sales
- Price / Earnings (or profits)
- Price / Cash Flow
The best practice is to use more than one of these when performing a business valuation. Overlapping ranges across a number of metrics can help support the final valuation. Ideally, you would look at for-sale multiples for businesses that are similar in type, size, and financial profile. Unfortunately, no two companies are exactly alike, which means you will need to make a judgment call based on the information available. If you are having difficulty or need help, you can search for a business broker or business valuation expert in the Firm Exchange Professional Directory.
Consider the Return on Investment when Valuing a Small Business
When it comes to small businesses in particular, people place a lot of importance on earnings and cash flow. Buyers tend to focus on their expected return on investment (ROI), or how much cash flow they expect to receive from the business relative to the price they are willing to pay. The ROI is the inverse of the multiple paid and is often expressed as a percentage. For example, buying a business with $100k per year of cash flow for $400k would be a 4x multiple, or a 25% annual return on investment.
Buyers will be looking for a wide range of ROIs based on the perceived risk of future cash flows. Buyers will generally accept lower ROIs for more certainty, but will demand higher ROIs when there is more risk. As such, the cash flow assessment is a critical part of the valuation. See our post about the Importance of Cash Flow for a more in-depth discussion.
When it comes to small businesses in particular, most people use earnings and cash flow. This is because buyers tend to focus mainly on their expected return on investment (ROI).
Comparable Transaction Multiples
Comparable transaction multiples (known as “comps”) are calculated and used in the same way as for-sale multiples. The only difference is that they are based on the sold values of comparable businesses. Comps better reflect actual prices paid, which is a major advantage over other metrics. However, comps can lose their value if the sold businesses differ significantly from the target business or if the transactions occurred too long ago. An additional problem with comps is specific to smaller businesses. Private companies generally don’t disclose the terms of any deals. As a result, it may be difficult to find enough comps to conduct your valuation.
Therefore, think about only using comps when there are transactions of similar businesses that have occurred recently. A good rule of thumb is that transactions are most relevant if they have occurred within the last three years. You should shorten that time frame if there has been a big change in the market over that period. For example, a recession might diminish the relevancy of prices previously paid. If there are one or more similar transactions that have closed recently, these will likely be the most relevant for valuing a small business. If you lack recent transactions, place more focus on for-sale multiples or a discounted cash flow analysis.
Discounted Cash Flow (DCF)
The final business valuation method we’ll discuss is an intrinsic valuation analysis. Intrinsic analyses are based solely on the business in question, as opposed to other companies. Simply speaking, a DCF attempts to value a business based on all future cash flow it will generate, discounted back to today. This last part is important: dollars today are almost always worth more than dollars tomorrow because of inflation. By discounting the value of future cash flows, a DCF corrects for this.
If you lack enough information about similar businesses, consider conducting a DCF analysis. However, be aware that this process requires many assumptions. Small changes in those assumptions can lead to wide swings in the implied price. If historical cash flow has been volatile or unpredictable, the worth of a DCF valuation can diminish greatly. Should this be the case, place more weight on the multiples analysis or a buyer’s expected ROI.
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DISCLAIMER: The information contained in this article is for informational and discussion purposes only, and should not be relied upon without seeking your own professional advice. The Firm Exchange, LLC is not a law firm, accounting firm or professional services firm, and accordingly it disclaims any liability for any reliance on the contents of this article. As each situation is unique, you are encouraged to discuss your specific situation with a qualified attorney, accountant and/or other relevant professional services provider.