Do you know what your company is truly worth? A business valuation helps you assess the total value of your company including assets, the potential for future revenue, and more. This helps you create a company roadmap that informs your day-to-day decisions.
What is a Business Valuation?
Business valuation is the process used by a company to determine its economic value or fair value. It answers the question, “What is my company worth?” in a variety of ways.
A valuation report may include a company’s capital structure, future earnings projections, the market value of its assets, and an analysis of its management, in addition to other metrics.
You may use your report if you want to finance expansion or add shareholders. If you’re going to buy a business or sell yours, you’ll use a valuation to help decide on a price.
There are many different methods to valuing a company, and not all techniques produce a similar result, even with many identical inputs. Valuations can change rapidly, depending on economic events or corporate earnings. The method by which professionals determine the worth of a company fits into two main categories:
Absolute valuation models look for a business’s intrinsic value as an investment. Valuers look at dividends, growth rates, and cash flow for a company without considering those metrics for other similar companies.
Relative valuation models compare a company to other companies in the same industry or sector. Using multiples and ratios like price-to-earnings, valuers compare the business to similar entities in the same sector.
Importance of Business Valuation
An accurate small business valuation allows its owner to plan for future growth, sale, or transition. They are essential to a variety of financial moves to facilitate the success of the company.
Without an accurate analysis, owners simply guess the fair market value of their business. This could lead to devastating financial mistakes like selling the company for far less than it’s worth, heirs paying more in estate taxes than necessary, or simply making a series of small decisions based on false assumptions.
Business Valuation Rule of Thumb
The business valuation rule of thumb is a quick measurement based on a single part of a company’s income stream, depending on the industry it operates in. In general, you should use your business type’s rule of thumb method as a reality check only.
There is a gold-standard valuation rule of thumb in certain industries that stands out among many options. In others, a valuation rule of thumb provides a simple metric to serve as a checkpoint for a more in-depth and accurate valuation.
Each business type can have up to three or more valuation rules of thumb. Here are some common types of small businesses that may be able to quickly assess their overall value using their industry’s business valuation rule of thumb:
Restaurants and bars: the going-concern business valuation method
Restaurants that turn a profit (whether they are a franchise or not) being sold to potential new business owners who intend to continue to operate the business as it has been in the past may use the going-concern method. This multi-step process involves determining the restaurant’s adjusted cash-flow earnings, assessing its profitability and growth potential, and assigning the appropriate multiple depending on the restaurant’s overall condition.
Medical practices (dentist office, physical therapy practice, family doctor’s office, etc.):
Stand-alone medical practices may compare themselves to other comparably-sized practices in the community. Unfortunately, there isn’t a universally recognized method for assessing medical practice comps. In general, medical practices may be valued at 1.5 to 3 times their gross annual revenue. Modern financial demands such as medical billing, groups of physicians employed by a single practice, and general office costs mean that medical practices can be valued less than their annual revenue.
E-commerce business (Shopify business or e-commerce store):
An online business can be challenging to assess, but in general, eCommerce stores sell for between 20 to 40 times their monthly net profit. This translates to 1.67 to 3.33 times their annual net profit. Valuation in the eCommerce space depends on several factors that are unique to the business. While it may be difficult to justify a valuation for an eCommerce company that falls outside the range of 1.67 to 3.33 times annual net profit, the range itself is wide enough to require more information before coming to an accurate valuation.
Boutique hotels (not branded):
In the United States, a small hotel typically sells for 8 to 11 times the EBITDA. A bed and breakfast establishment sells for between 8 and 9 times the EBITDA. While this isn’t a named rule-of-thumb, it is a widely used standard in the industry.
There are several acceptable rules of thumb for small business valuation of an accounting practice. Still, the 1 to 1.25 revenue method is a widely accepted standard by which to quickly come to a valuation for an accountant’s office.
Standard Methods for Valuing a Business
There are several methods by which a business may determine its value. Each method uses information about income, market data, or assets to reach a value. The method that works best for your business depends on the size of your company, the type of industry it operates in, and your goals for the valuation.
Income-based business valuation method
The income-based business valuation method uses two standard valuation methods to determine how much money a business may produce. A newer firm with a lot of growth potential that doesn’t show profit may use the discounted cash flow method. By determining the value of future cash flow and adjusting for risk, the discounted cash flow method provides an accurate forecast of a new business’s value.
An established business with steady profits may use the capitalization of earnings method to determine future profitability. Using an annual rate of return (ROI) and the business’s cash flow, this type of valuation assumes that past profits will continue at a similar rate.
Asset-driven business valuation method
An asset-driven business valuation involves making a detailed list of business assets with appropriate monetary values. Business owners are often well-equipped to handle
this valuation because they are familiar with their production trends and equipment. Asset-driven valuation methods may help fill in a business valuation if the company isn’t profitable, if it is undergoing liquidation, or if you are seeking a loan.
The adjusted net asset method uses information about a company’s property, inventory, and equipment, as well as its liabilities. After both are adjusted to fair market values, the difference between assets and liabilities offers a snapshot of a company’s value.
Market-driven business valuation method
A market-driven business valuation establishes your business’s value by comparing it to similar companies while making adjustments for small differences between the comparisons. If several companies like yours have recently sold, that information determines your market-driven valuation.
In the absence of a sufficient number of comparable businesses, you may have to rely on one of the other common business formulation methods.
The market-driven valuation method works well for businesses in a growth phase.
Future maintainable earnings valuation
Future maintainable earnings valuation works by using historical financial performance to estimate future financial performance. A valuation expert considers historical transactions, including:
• Owner-related expenses
• Financing costs and capital structure expenses • Assets not crucial to business operations
• All revenue and expenses
• One-off expenses
Companies with stable historical earnings often use the future maintainable earnings valuation method when they expect future earnings to remain consistent.
Discount cash flow (DCF) valuation
One of the most popular methods, discount cash flow (DCF), forecasts future earnings over a number of years using expected cash flows while considering the time value of money (TVM). The value of your business is not the same as it will be in the future because of its earning potential, but money received in the future is worth less because
of inflation. TVM discounting is an important part of DCF valuation calculations when investment projections go further than a year into the future. Each year of forecasted earnings receives a discount rate that accounts for TVM.
Pre-Money vs. Post-Money Valuation
Pre-money and post-money valuations depend on the timing of the valuation. If you cannot use earnings before interest, taxes, depreciation, and amortization (EBITDA) and revenue, it’s essential to understand pre-money vs. post-money valuations. Companies on the cusp of exponential growth (big ideas and small cash flow) and startups in the pre-revenue stage may use multiple valuation methods blended together to arrive at an accurate valuation that facilitates their future growth.
Post-money valuation is the amount of money a business is worth after receiving funding. Capital injection and outside funding + Pre-money valuation = Post-money valuation
The pre-money valuation of a business occurs before funding.
Pre-money valuation = Post-money valuation – funding
Valuation for a sole proprietorship
Using the market-driven business valuation method or the asset-based valuation method can be difficult if your business is a sole proprietorship. Even so, there are certain circumstances where the business owner must know the exact value of their business. For example, suppose you are planning to retire, using your business to finance a loan, going through a divorce, acquiring a partner, or going through the process of succession planning. In that case, your small business valuation is an integral part of the process.
Even though valuing your sole proprietorship can be complicated, it’s possible to get an accurate picture with help from experienced valuation professionals.
Income-based valuation for a sole proprietorship
A sole proprietorship’s success may rest firmly on the owner’s relationships with clients. In a service-based industry it’s important to consider that a percentage of business may
be lost due to no fault of the new owner, simply because some clients preferred working with the former owner.
Asset-based business valuation for a sole proprietorship
Corporations own all business assets, so the potential buyer purchases a definitive list of assets as part of the business’s sale. If your business is a sole proprietorship, assets may also be your personal property, which can make determining your value difficult. You must separate your company and personal assets before conducting an asset-based business valuation.
Market-driven business valuation for a sole proprietorship
A sole proprietorship is never a publicly-owned company, so getting information about similar companies to create market-driven business valuation can be particularly difficult.
Valuation for a franchise
Before seeking a business valuation method for your franchise, consult your franchise agreement. Many franchise vendors dictate how you can sell your franchise. In some cases, the franchisors will purchase your franchise for a predetermined fixed price, making a valuation unnecessary.
Other franchisors may help you with the valuation process and offer assistance throughout the sales process, as well.
Why do You Need a Business Valuation?
Business owners seek a business valuation for a variety of reasons. Taking time to measure the potential and value of their company is one way that entrepreneurs measure their ongoing success. Business valuations can help owners plan for growth, justify investment initiatives, and assess the company’s overall potential. Here are a few reasons you may need a valuation:
Plan for retirement
For business owners, retirement is more complicated than writing a resignation letter to formally announce that you’ll be leaving the company in a few weeks. Whether you are nearing the traditional retirement age or are ready to pull the lever on your long-term plan to retire early, having a well-planned exit strategy will help stabilize your future financial situation while ensuring the ongoing success of the company you worked so hard to build.
The baseline value established by your business valuation will help you design an exit strategy that serves you, your employees, and the future leaders of your company.
Develop a plan to sell your company
Selling your company could require a master plan spanning five years or more. With an accurate business valuation, you can assess your company’s financial health to inform your plan to sell. You may need to make certain improvements to your business or reach a few goals further down on your timeline before you can get the best possible price for your company. Understanding your current financial situation will help you see exactly where you are on your journey toward selling your company.
Protect your company
Understanding the genuine value of your business allows you to adequately protect it from legal problems, tax issues, or the divorce or death of any of the company’s owners. Your company’s value can inform the decisions you make about whether to hire a lawyer, review partner agreements or take out key-person life insurance policies.
Understand your company’s growth potential
An accurate baseline value helps you create an informed growth plan that includes marketing objectives, financial goals, and business strategies. Companies committed to meeting the challenge of year-over-year growth often commit to annual business valuations so they can understand exactly where they are and use that information to reach their goals.
Work with potential lenders
At some point, most companies need a financial boost in the form of a loan or line of credit. You may want to acquire a competitor or open a new revenue stream, and doing so could require financing a loan. Periods of rapid growth may need an infusion of cash, even if it’s just a short-term loan.
Lenders use business valuations to show underwriters that you are secure and that your past financial performance will likely translate to future success. A valuation can help you prove to lenders that you’ll be able to make payments on time and as agreed.
The value of your business may determine whether your heirs will pay hefty federal estate taxes or receive an exception. Having an accurate and recent business valuation saves your loved ones from having to go through the arduous process of combing through your company’s books to determine its value.
Comply with divorce proceedings
When it comes to divorce, the court generally accepts a fair market value as a business valuation method. Even if you don’t intend to sell your business, understanding its fair market value will help the court determine the value of all assets considered in the divorce. The court may also accept the income approach to avoid double-dipping when calculating the equitable distribution of assets.
Each jurisdiction has the legal right to impose a standard of value regarding corporations in divorce. Your attorney will provide relevant guidance.
Buy-sell agreements with partners
Suppose a partner wants to sell their share of the company. In that case, a business valuation can help keep the company under the ownership of the other partner by facilitating a smooth transition. A buy-sell agreement outlines the terms of a buyout if a partner is injured, dies, wants to retire, or simply wants to pursue other interests while shedding the responsibility of business ownership.
The Internal Revenue Service (IRS) uses a business’s fair market value to oversee tax-related events like gifting of shares or a company’s sale or purchase. A business owner can give away stock to family members as part of their succession plan. They may also choose to reward key employees with gifted stock.
Considerations Before Conducting a Business Valuation
When valuing a company, business owners are subject to several market conditions, subjective opinions, and unknown variables. The onslaught of information can be overwhelming. Valuing a company often involves making assumptions, which can drastically alter the outcome.
While valuations may change over time, it’s important to remember that the market value of your business at a certain point in time isn’t permanent, nor is it an unfailing prophecy about the future of your business.
It’s crucial to consult various data sources, no matter which valuation method you choose. When you hire a professional to help with your valuation, make sure that the data offered is as complete and accurate as possible. Lack of data increases the likelihood of receiving an inaccurate business valuation. Unfortunately, finding accurate data from other business valuations is a time-consuming project. In many cases, entrepreneurs, analysts, and investors must make an educated guess when determining company values.
Many business owners prefer to consult financial professionals to obtain an accurate understanding of the value of their company.
How to Use Your Business Valuation
An up-to-date business valuation provides key information about a company’s asset values, income values, and the business’s actual worth in the marketplace. Getting a fresh valuation each year lets you measure growth.
This may simply be a single number without any caveats, for example “$100,000”. If the value of a business asset depends on a variable that fluctuates in value, you may receive a price multiple as a valuation. Your valuation analysis may also include a net asset value (NAV) per share or asset value per share.
A valuation can help investors understand the intrinsic value of a company’s shares so they can decide whether (and how much) to invest. Valuation analysis also helps to estimate the return on investment over time. Your valuation can open doors to new investors interested in helping your company level up.
A valuation assessment shows exactly which assets a company owns, and it estimates their worth. You can use this to obtain the correct types and amounts of insurance to ensure your assets are protected. Understanding the current value of a company’s assets allows you to plan for how much money to reinvest into the company, as well.
What Can You Do With a Business Valuation?
Your valuation involves a number of assumptions about your capital expenditures, margins, financing choices, and sales growth. Even so, it’s a useful tool that helps owners and partners perform crucial tasks.
Predict the future with some accuracy
Future outlook is a big priority for business owners with a growth mindset. To create additional value, it’s crucial to understand the current value. A business valuation helps company leaders formulate a plan to move forward toward their goals. With a correct valuation in hand, a company can make accurate forecasts of revenues, determine future operating expenses, and understand upcoming capital requirements. Comparing these metrics to other similar companies in the sector offers even more insight into the business’s potential for growth.
Compare the company’s past performance to other businesses
Understanding past performance is the key to planning future growth. Using several years’ worth of business valuations, specifically sale prices for certain transactions and price-to-earnings (P/E) ratio, companies can see how they’ve grown over time. They can also use this data to compare their growth to other companies in the same industry.
Valuations can help you see if your company is lagging behind other businesses in your sector or if you are pulling ahead. This type of data can help justify changes to business practices to help continue or spur growth. It can also help justify an increase in the marketing budget or upgrade to essential equipment.
Establish a track record of measured success
Businesses that need an infusion of cash may turn to a traditional lender. Alternative lenders, peer-to-peer lenders, and investors may also require proof that your company is financially sound before they are willing to offer a loan.
Your valuation (or, better yet, several years’ worth of valuations) can help you establish a track record of success to help instill confidence in potential lenders. Your lender is most interested in your business’s value if it were for sale today. There’s more to getting a loan than showing a solid valuation, of course. The bank will also collect information about your outstanding debts, your business and personal credit, current client contracts, the status of your lease, and the strength, weakness, opportunity, and threat (SWOT) analysis of your business.
Getting a non-accredited valuation is one way to get important information about your company without spending thousands of dollars to access the data. Tracking your most significant asset (your company) is a complex process as a DIY project.
What you will need
You can get a non-accredited valuation by simply connecting the online version of your Quickbooks or Xero accounting software to GrowGrade. Business owners can also choose to enter their company’s information manually. Here’s what you’ll need to get started:
Three to five years’ worth of the company’s: • Revenue
- Cost of Goods Sold
- Owner’s Compensation
- Cash (and Cash Equivalents)
- Long-term Debt
Using a discounted cash flow model, GrowGrade’s business valuation formula quickly and accurately projects the future value of your business. Using historical financial information, the algorithm calculates your average growth rate and applies it to future free cash flows. Taking the net present value of three years’ worth of future free cash flows allows us to account for risk.
The GrowGrade value = net present value of future free cash flows + cash and cash equivalents – long-term debt
Scenario Modeling with GrowGrade
Business owners can test their company’s valuation using different scenarios using editable fields to test assumptions. For example, it’s easy for a company owner to see how expanding their business using debt would affect the business’s valuation. Scenario modeling helps small business owners see precisely how their valuation changes when they adjust the cost of goods sold, owner’s compensation, revenue, expenses, cash and cash equivalents, and long-term debt.
Common business valuation mistakes
One of the most critical aspects of determining the market value of a company is getting the assumptions informing the discount rates, cap rates, and earnings correct. Many business owners are surprised at the result when they try the DIY approach. It’s crucial to get the historical information right when determining the value of a company.
Cash flow prediction errors
Business owners tasked with independently predicting the future success of their company may overestimate future cash flow. It’s common for optimistic revenue forecasts to throw a valuation off track, resulting in an inaccurate estimate of a business’s actual ability to generate revenue.
Inaccurate capital expenditure
Growing companies may show temporarily inflated fixed asset costs. These costs result in eventual revenue increases but can throw a valuation off track. Professionals conducting valuations understand how to account for short-term fixed asset cost increases.