Business valuation is the practice of estimating how much a business is worth. It lets business owners who want to sell put a price on their businesses, and it helps potential buyers decide whether to make a purchase.
Investors and lenders also like to know the market value of a business before putting money on the line.
How valuation is calculated
We’ll take a look at both basic business valuation and advanced business valuation methods. The basic approach is good for small businesses and side hustles, or for getting a ballpark figure for your own sake. The advanced approach builds on that, and takes extra variables into account.
Essential data for business valuation
Whether you use a basic or advanced approach, the following records are absolutely essential for valuation.
- Financial statements for at least the last three years
- Copies of all the business’s tax filings and returns
- All licenses, deeds, patents, and other proprietary documents
- An up to date balance sheet for the business
The more information you have about your business, the more accurate your calculations will be when you value it.
Present value vs. book value vs. fair market value
The value of your business isn’t just one, static amount. There are three values commonly attached to a business. Each one is different, and shows a different aspect of the company’s financial health.
The book value, also called liquidation value, is the most straightforward. It’s the same as your net worth—your value recorded on the books. Once you subtract all your liabilities from all your business assets, you get your book value.
The present value of your business takes into account current and future cash flows to figure out what your business is worth now as well as later on. This determines whether or not your company is a going concern—a business with stable future earnings, that can keep operating indefinitely without being liquidated.
The fair market value is the price your business is likely to fetch on the open market. If you’re selling, you’ll use this number to set a price on your business when you meet potential buyers.
We’ll cover the most common methods of book, present, and fair market valuation below.
The business valuation formula
The simplest way to find the value of a company is by using the income approach. It’s based on seller’s discretionary earnings (SDE). The purpose of SDE is to measure how much money a business brings in for the person who owns it—regardless of who that is.
If you own a business, the taxes you pay, your owner’s draw, and other non-essential expenses are tied to you. Your SDE consists of your net income, minus those expenses.
Calculating your SDE
You’ll calculate your SDE for the previous financial year—since you ought to have all the business records for it.
Expressed as a formula:
(Net earnings before taxes + personal draw + non-essential expenses) – liabilities
Here are the steps to take:
Take your business’s net earnings before taxes for the year
Add to that number whatever you paid yourself (your personal draw)
Add to that number all the non-essential expenses you incurred over the course of the year. These are one-time, non-repeating expenses. Do not include cost of goods sold
Deduct any liabilities—debts, unpaid bills, and so on
The final number is your SDE
Essential vs. non-essential expenses
Essential expenses are fixed—they’re key to how your business runs, and they’re the same month to month. Examples include:
- Rent and property taxes
- Business insurance
- Light, heat, and other utilities
Non-essential expenses often vary month to month. They’re not key to keeping your company in business. Examples include:
- Travel and meal expenses
- Equipment repairs and upgrades
- Staff events
Let’s say you’re calculating the SDE for your company Fizz Off, which makes bath bombs. Last year, you bought materials, rented a space for manufacturing, ran an online store, and paid a part-time employee who took care of packaging and shipping and ran your social media accounts. All of these are essential expenses—without them, Fizz Off wouldn’t be the successful business it is.
Those weren’t all your expenses last year, though. You travelled to a bath bomb conference in Bath, England. You bought five pounds of pink glitter, for a new experimental bath bomb (“Grapefruit Sunrise”). And you rented a table at a local craft fair. These are non-essential expenses—you incurred them in the course of doing business, but they were one time transactions, not essential for keeping Fizz Off in business.
Also called an “SDE multiple,” your industry multiplier is a number that you multiply your SDE by to get the fair market value of your business.
How the industry multiplier is determined
Industry multipliers are determined by business appraisers, who take into account a number of factors:
- The size of your business
- Trends in your current market
- What industry you’re in
- Your business’s tangible assets (real estate, equipment, cash) and intangible assets (client list, intellectual property)
- How much the value of the company comes from your personal skills or brand
- Additional variables
Why use a multiplier?
You may be asking yourself, “Why can’t I just price my business using my SDE?” Here’s why.
SDE consists of how much money a business can be expected to earn over the course of the year, minus taxes, owner’s draws, and non-essential expenses. It doesn’t speak to the long-term value of the business. The multiple takes that into account.
Now imagine there are two companies: A virtual reality design studio, and a typewriter parts manufacturer. Due to the mysterious workings of the universe, they both had the same SDE last year. Would you say they’re both worth the same to an investor?
Probably not. Even though a small chunk of the population continues to use typewriters, there’s not much growth potential in the industry. At least, not nearly as much as there is for a tech firm designing the next generation of VR.
The SDE multiple takes that difference into account, so each company can be valued appropriately.
Who decides the multiplier?
If you hire a consultant or appraiser, they should be able to walk you through the process of how they select an SDE multiple for your business.
If you’re handling your own valuation, though, you’ll need to get your own SDE multiples. Firms that specialize in business valuation publish guides with up to date multiples. Typically, you’ll need to fork out some cash for one.
Start by checking out the 2020 Business Reference Guide from Business Valuation Resources, then follow up with your own research online.
Business formula methods
There are four major valuation approaches for advanced business valuation. You need to choose the one that is most appropriate for your business.
Treat this as a jumping off point. Once you’ve figured out which method is right for you, you’re ready to do further research or meet with a consultant.
|Method||How to calculate||What you need||Best for…|
|Market approach||Determine a value based on the sale price of similar businesses in your market||Sale prices for other businesses in your industry, possibly obtained with help from a consultant||Fair market value. Any business.|
|Capitalization in earnings||Create a business forecast based on your previous years’ income and expenses, and base your valuation on it||Past years’ tax returns and financial reports||Present value. Well-established businesses with a stable income or steady growth|
|Discounted cash flow (DCF)||Figure out a value based on your business’s current cash flow, then discount some of that value based on risk (chance of future losses)||Business consultant||Present value. New businesses that have a lot of potential for growth, but are not yet profitable|
|Asset-based||Add up all the tangible assets of your business (real estate, equipment, cash), taking into account depreciation), then subtract liabilities||An up to date balance sheet||Book value. Companies that are liquidating—selling off their assets and going out of business|
Business valuation services
If you’re planning for a business sale, and you don’t have time to do a lot of research and calculations, you may want to hire a business appraiser.
An appraiser uses their expertise and experience to determine your business’ value. They’re usually tuned in to current market trends, and may be able to give you a more accurate number than one you’d calculate on your own.
When considering an appraiser, look to see if they have any of the following credentials:
- ABV (Accredited in Business Valuation): A credential for Certified Public Accountants who’ve completed 75 hours of business valuation coursework and passed a business valuation exam.
- ASA (Accredited Senior Appraiser): They’ve completed over 10,000 hours of appraisal work, passed multiple examinations, and had their work reviewed by peers.
- CBA (Certified Business Appraiser): They’ve passed a rigorous peer review process.
- CBI (Certified Business Intermediate): They have intimate knowledge of business sales and purchases.
Always be certain of an appraiser’s credentials before you hire them. There is a large amount of money on the line when you have a business appraised, and only a trained professional can assign a realistic and useful value to your business.
Ready to cash out? Learn the basics of how to sell your business.