How to Value a Small Business

‍Why Accurate Valuation Matters

Understanding the true value of your business is important. Overvaluing can deter potential buyers, while undervaluing can lead to significant financial loss. Utilizing valuation tools and methods ensures you price your business optimally for your desired outcomes.

Why is accurate small business valuation important?

• Overvaluation: Can scare off potential buyers.
• Undervaluation: Can lead to financial loss.
• Proper Valuation: Helps in fair pricing, attracting the right buyers, and smooth negotiations.

Methods to Value a Small Business:

1. Earnings Multiplier (Price-to-Earnings Ratio)

How It Works: Multiply the business's earnings before interest, taxes, depreciation, and amortization (EBITDA) by an average industry-specific multiplier. This reflects both current profitability and future potential. 

As you begin to learn more about how to value a small business using this method, there are several resources available online for understanding what these average industry multipliers are. We are working on a comprehensive resource for you right now, so make sure to come back to SMB.co in the coming weeks, and we will have this data for you.. 

Example: If your business has an EBITDA of $100,000 and the average industry multiplier is 4, your business value is $400,000.

Pros of the Earnings Multiplier Method:

• Simple Calculation: Easy to understand and apply.
• Profitability Focused: Highlights the business's earning potential.

Cons of the Earnings Multiplier Method:

• Variable Multiplier: The multiplier can vary significantly by industry and market conditions.
• Dependent on Accurate EBITDA: Requires precise calculation of EBITDA to be reliable. So, basically any errors, misunderstandings, or inaccuracies in the EBITDA calculation can lead to misleading valuations, affecting the reliability and credibility of the valuation outcome.

Summary: Earnings Multiplier

• EBITDA: Earnings before interest, taxes, depreciation, and amortization.
• Multiplier: Industry-specific number used to calculate business value.
• Example: $100,000 EBITDA * 4 = $400,000 business value.

2. Asset-Based Valuation

How It Works: The Asset-Based Valuation method involves calculating the value of a business by summing all its assets (both tangible and intangible) and subtracting its liabilities. This approach is particularly useful for businesses with significant physical assets, such as real estate or machinery.

Example: If your business has $500,000 in assets and $200,000 in liabilities, the business value is $300,000.

Types of Assets and Liabilities for a Typical Small Business:

What are assets?

1. Tangible Assets:
   • Real Estate: Office buildings, warehouses, retail spaces.
   • Machinery and Equipment: Manufacturing equipment, computers, vehicles.
   • Inventory: Products ready for sale, raw materials, and supplies.
   • Furniture and Fixtures: Office furniture, store fixtures, and shelving.
2. Intangible Assets:
   • Intellectual Property: Patents, trademarks, copyrights.
   • Goodwill: The value of the business’s reputation, customer relationships, and brand.
   • Software and Licenses: Proprietary software, software licenses.
   • Customer Lists: Databases of customer information.
3. Financial Assets:
   • Cash and Cash Equivalents: Bank accounts, petty cash.
   • Accounts Receivable: Money owed to the business by customers for products or services delivered.

What are liabilities?

1. Short-Term Liabilities:
   • Accounts Payable: Money the business owes to suppliers.
   • Short-Term Loans: Loans or lines of credit that need to be paid within a year.
   • Accrued Expenses: Expenses that have been incurred but not yet paid, such as wages, taxes, and utilities.
2. Long-Term Liabilities:
   • Mortgages: Long-term loans secured by real estate.
   • Long-Term Loans: Loans that extend beyond one year, such as equipment financing.
   • Deferred Tax Liabilities: Taxes that have been accrued but not yet paid.
3. Other Liabilities:
   • Lease Obligations: The cost of leases for property or equipment.
   • Bonds Payable: Debt securities issued by the business.
   • Pension Obligations: Retirement benefits owed to employees.

Pros of the Asset-based Valuation Method:

• Clear Calculation: Provides a straightforward value based on tangible assets.
• Useful for Asset-Heavy Businesses: Ideal for businesses with substantial physical assets.

Cons of the Asset-based Valuation Method::

• Ignores Future Earnings: Does not account for the business's potential to generate future income.
• May Undervalue Intangible Assets: Intangible assets like brand reputation or customer loyalty might be undervalued.

Summary: Asset-Based Valuation

• Assets: Everything the business owns (equipment, inventory, property - see the more comprehensive list above).
• Liabilities: Everything the business owes (debts, loans, other items from the list above).
• Calculation: Assets - Liabilities = Business Value.
• Example: $500,000 in assets - $200,000 in liabilities = $300,000 business value.

3. Discounted Cash Flow (DCF)

How It Works: The Discounted Cash Flow (DCF) method involves forecasting the business's future cash flows and then discounting them back to their present value. This method provides a dynamic view of the business's potential earnings over time and can be particularly useful for businesses with predictable cash flows.

Step-by-Step Example:

Step 1: Forecast Future Cash Flows

Imagine the business will make $50,000 each year for the next 5 years.

Step 2: Choose a Discount Rate

Let's say we use a discount rate of 10%. This rate is like saying money today is worth more than money in the future due to risks and time value.

Step 3: Calculate Present Value (PV) for Each Year

Use this formula:

Where:

• PV = Present Value
• Future Cash Flow = Money the business will make in a future year
• Discount Rate = 10% or 0.10
• n = Year number (1, 2, 3, etc.)

Step 4: Add Up All Present Values

Step 5: Sum All Present Values

To find the total present value of all future cash flows, sum the present values calculated for each year:

So, the business is worth $189,540 today based on future cash flow projections and the chosen discount rate of 10%.

How to Determine the Discount Rate:

The discount rate can be thought of as the required rate of return or the cost of capital. Here’s how to determine it:

1. Cost of Debt:
   • The interest rate paid by the business on its borrowings.
   • Can be found from the company’s financial statements or market data.
2. Cost of Equity:
   • Calculated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + (Beta × Market Risk Premium)
   • Risk-Free Rate: The return on government securities (e.g., 10-year Treasury bonds).
   • Beta: A measure of the business’s volatility compared to the market.
   • Market Risk Premium: The additional return expected by investors for taking on market risk, typically calculated as the difference between the expected market return and the risk-free rate.
3. Weighted Average Cost of Capital (WACC): Combining the cost of debt and the cost of equity gives the WACC, which serves as the discount rate for the business.

• E.g., Cost of equity is 8%, cost of debt is 6%, with a 40% debt and 60% equity structure, and a 30% tax rate, WACC is around 6.48%.

Determining the discount rate involves understanding the risk profile of the business and the market environment. Utilizing a combination of the cost of capital approach, industry benchmarks, and professional judgment helps ensure that the discount rate accurately reflects the risk and expected return for the business.

Pros of the Discounted Cash Flow Method:

• Reflects Future Profitability: Considers the potential future earnings of the business.
• Comprehensive Analysis: Accounts for various financial aspects and scenarios.

Con of the Discounted Cash Flow Method::

• Complex Calculation: As you can see above, this method is complex, to say the least. It requires detailed financial forecasting and understanding of discount rates.
• Sensitive to Assumptions: Highly dependent on the accuracy of future cash flow projections and discount rates.

Summary: Discounted Cash Flow (DCF)

• Forecast: Estimate future cash flows.
• Discount Rate: Used to calculate the present value of future cash flows.
• Example: Calculate the present value of $50,000/year cash flows for 5 years at a 10% discount rate.

4. Market Comparisons

How It Works: The Market Comparisons method involves looking at similar businesses in your industry that have recently sold to get a ballpark figure for your business's value. This method is particularly useful for understanding the current market conditions and trends.

Example: If similar businesses in your industry sell for $250,000 to $350,000, your business value likely falls within this range.

Pros of the Market Comparison Method:

• Market-Driven: Reflects current market conditions and trends.
• Easy to Understand: Provides a straightforward comparison.

Cons of the Market Comparison Method:

• Finding Comparables: It can be challenging to find businesses that are truly comparable.
• May Not Reflect Unique Aspects: May not fully account for the unique strengths or weaknesses of your business.

Summary: Market Comparisons

• Comparable Sales: Look at recently sold similar businesses.
• Example: Similar businesses sell for $250,000 - $350,000.
• Use: Gives a range for your business value.

How to Value a Small Business with SMB.co

At SMB.co, we offer a range of resources and expert advice to guide you through the valuation process. Whether you need detailed market analysis, valuation calculators, or access to experts, we are here to support you every step of the way.

‍

‍