The first step in any business sale is knowing how much your business is worth. It is not uncommon for savvy buyers to take advantage of unprepared sellers who have no idea what their company is worth, so it is fundamental to include a professional valuation as part of any effective exit strategy. However, when many business owners decide to sell, they are often left asking “How do I value my company?"
There is no one simple answer to this question, as there are several different ways to value a company. Each has its own advantages and disadvantages depending on a number of factors, from the current economic market, and interest rates to industry valuation norms. Choosing the right method to value your business will play a significant role in the return on your investment when you exit.
One of the biggest errors business owners can make when approaching a company valuation is not seeking professional guidance. With the amount of time and energy you devote to running your business, it is virtually impossible to look at this objectively. With guidance from a leading middle-market valuation firm like Generational Equity, you will learn how to unlock hidden value in your business financials.
Here, we offer an introduction to three of the most common company valuation methods and how they can be applied to your business.
Every business is constructed of assets and liabilities. By calculating the difference between these assets and your liabilities, you will be able to estimate the “book” value of your business. Rather than showing the profit-generating capabilities of a company, this method offers the current net worth, on paper, of the company.
For this reason, this approach is often used when a company goes into liquidation. In this situation, an owner is often being forced to sell for less than optimal reasons. However, the best time to consider selling to get the optimal deal is when your business is doing well and making money. This approach doesn’t consider future earnings, so it is usually not the best method for a prospering business.
Asset accumulation is easy to calculate and will provide the minimum value of a company. However, one of the greatest disadvantages of this method is that for many businesses, the value of equipment and machinery has been fully depreciated so the book value is typically far below the actual value of the equipment and machinery upon liquidation. And again it does not take into account the most important factor: The future earnings of the company.
For smaller companies, an approximate business value can be based on the valuation norm within the industry that you operate. This is important through the eyes of a business buyer, who will be aware of the ‘standard’ company worth for a specific industry.
Providing there are enough similarly-operated businesses within your industry, this simple approach offers a sound valuation benchmark that encapsulates the current market. Comparable valuations can be used as a rule of thumb to estimate the value of a company and is a great way to support your offer or asking price.
However, a cause for concern when looking at industry valuation norms is the reliance on the assumption that companies operate in the same manner. While also depending on the notion that other companies in your area have been accurately valued, no two companies are alike, which can often lead to comparing apples to oranges. Using this method as the sole valuation tool risks leaving the business seller, especially first-timers, disappointed at the difference between the predicted value and the final offer.
Also, keep in mind that any multiple that you read about that is “standard” for your industry is at best, an average of all completed deals historically. The downside to using any average measure is that it is an average value. In the real world, this means that there are companies valued above and below the average. And do you have an average company? Or is it an over-performer.
Secondly, industry norms are by their very definition are created using years of historical data. Again, it does not factor the future in at all. So this method is less than optimal if you are valuing your business. However, keep in mind that buyers use this method because they know it will usually undervalue the company they want to acquire.
The true value of a business lies in its capacity to produce wealth in the future. Unlike the previous two methods, an income approach such as DCF takes into consideration the expected future earnings of a company together with the risks the company faces. This offers a well-rounded approach towards an accurate valuation of a company’s worth for both sellers and buyers by calculating the current value of the future wealth generated.
In order to determine this, it is necessary to project the EBITDA of your company for future years, which will typically be a five-year projection. A high level of accuracy is required when forecasting future cash flow, which is why we encourage business owners to talk to our experienced valuation team.
Next, the rate of return that will make this business purchase a worthwhile investment is considered and a discount rate is determined. The discount rate reflects the risk of reaching the projected income. This rate is applied to your future earnings and the current enterprise value of the company is determined.
So the DCF is dependent on two factors: Your projected earnings (usually EBITDA) and the discount rate used. Not surprisingly, the higher the discount rate, the lower your business enterprise value today. Conversely, the lower the discount rate the higher your business will be valued (all other things being equal).
And what determines the discount rate? The level of perceived risk associated with your projected earnings. This is why we strongly counsel our clients to work with us to create believable, defendable projections of revenue, expenses, and EBITDA. The more realistic, the lower the risk associated with your business.
Also, it is vital that before you create our pro forma projections, that you “recast” your historical financials to reflect the true profitability of the company. Let’s be honest, over the years you and your account have worked really hard to reduce your tax liability. There is nothing wrong with this, it is perfectly legal and acceptable.
However, if you don’t recast or normalize your historic numbers, you could be radically understating your company’s true profitability, thus misrepresenting your future profits, and hurting your company’s DCF value calculation. So be sure to have your financials recast by an experienced M&A advisory firm like Generational Equity before applying the DCF model.
Finally, keep in mind that we have presented only three methods of business valuation, there are lots of others. If you hire an experienced M&A firm to work with you, they will ultimately use a number of methods in combination to come up with the one (or several) that make the most sense for your company. Again, this is another reason why you need to work with a team that has experience in wide range of valuation methodologies.
Being unaware of the different company valuation methods available to you could stand in your way of achieving the optimal value for your company. If you are interested in learning more, set aside a few hours to attend a Generational Equity executive conference. These complimentary, no-obligation conferences run throughout North America and provide a highly educational opportunity for business owners to understand how much their company is worth.
As one of the leading M&A advisory firms in the lower middle-market, Generational Equity provides the necessary information, guidance, and support throughout the entire M&A process – starting with your business valuation. For more information, follow these links:
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