How To Do a Business Valuation (9 Ways)

A business valuation estimates the price someone is willing to buy a business.

This article is tailored for an independent businessperson that wants to know the best ways to do a business valuation; it:

1. walks you through 9 options
2. explains which alternative is most useful, when and why, and
3. suggests 5 next steps.

Reading Time: 13 minutes

Why do you want a business valuation

You may want an accurate snapshot of your business, simply so. You may be seeking to take on debt or add equity partners. You may have other personal reasons. For clarity, let’s assume that you are interested in exiting the business and are looking to sell it outright.

Although the business valuation discussion applies regardless of your motivation, it is important that you are clear on why you want the valuation. Keep that why foremost in your mind so you do not get sidetracked by anything or anyone.

Including me.

First Things First

The price of a business, as the saying goes, is what a buyer will pay and the seller will accept. Ultimately, the price is a function of the intrinsic value of the business, the overall market conditions and the eagerness of the seller and the buyer.

There is little to nothing you can do to change overall market conditions. What you can change is what makes your business valuable: its profitability, its solvency, and its liquidity.

Just as you probably do not want to buy someone else’s problems, few buyers want to buy your problems. Unless you are prepared to sell at a discount, the best thing you can do to get a good price for your business is to operate a profitable, growing business with a clean balance sheet and financial records that can withstand thorough due diligence.

The business should have systems and processes in place that reduce or eliminate reliance upon you being involved in the daily operations. It is best to think of yourself as an active investor in the business, the Chairman of the Board, with a principle-based (systems and processes) management team reporting to you.

Nevertheless, a business valuation is done to appraise or estimate the market value of a business. For privately held businesses, the business appraisal is primarily done to prepare for business sale or merger and debt or equity financing.

Nine [9] Business Valuation Methods

These nine [9] alternatives can be grouped into one of three primary business valuation methods—from simple to complex:

1. asset based—based on historical performance to date
2. market based—based on current and near-term performance
3. discounted cash flow—based on forecasted performance

Each of these methods has value. I will walk you through each method, why it is important, when it is most useful and how to do it (for yourself or with some help).

Asset Based Business Valuation

Asset based valuation is based on historical performance to date. It is the most conservative approach. You can think of it as establishing a price floor. Even if you had to liquidate (orderly, not in a rush), the business should be worth at least this much.

Asset based valuation ignores intangibles like customer relationships, vendor relationships, proprietary know how, good will (depending on how you have treated this historically) and so forth. The method includes items that would be ignored or discounted if the business were being liquidated or otherwise sold in a hurry.

The asset-based valuation method has two variations:

1. book value: net asset value—that is, assets less liabilities
2. cost to (re)build – as if the company were to restartup operations

book value

Book value is net worth, also known as equity. Book value is the net asset value or the value of all assets less the value of all liabilities. It is the residual equity on the company’s balance sheet statement.

If liabilities exceed assets, the business has negative equity, negative book value and is bankrupt in the strictest sense of that word.

This method is most useful in unpleasant liquidation situations where the business is no longer viable or operational. Sadly, 80% of listed businesses do not sell—due to lack of prior planning. Book value, though, is useful in generating a valuation where the business is ongoing but, perhaps, has no earnings per se.

Book value is typically lower than market value for a profitable, ongoing business. It can be used if the company is not operational or not profitable. It can be used as a sanity check; in which case it most often is used to create the multiplier price-to-book ratio (described below).

Here though, book value is simply that—the net asset value of the business as it is listed on the company’s balance sheet. Most often used in the course of a liquidation.

cost to build / rebuild

Depending on the complexity of the business, it can be time consuming to rollup the cost to rebuild or reacquire all of the assets and materials needed to run the business—whether or not these assets are listed on your balance sheet as fixed assets. Buildings, land, vehicles, machinery, furniture and fixtures, office & computing equipment and so forth may be owned by the business. The business may rent or lease some or all of these items. You also need to think about the labor costs to rebuild the business: recruiting, hiring and so forth.

You can take a minimalist view of these rebuilding/startup costs—which for current purposes undervalues your business. You can take a maximalist approach to increase the valuation, though it might not be realistic.

The key is to determine how much time and money would it take to setup a completely new, identical operation that could compete against the current operation. Again, this is time-consuming and there are quicker ways to get a better valuation number.

Net-net: asset based valuation methods provide a baseline, conservative estimate of what a business is worth at the very least; especially if, for whatever reason, you are liquidating the company or being forced sell in a hurry.

Market Based Business Valuation

Market based valuation is based on current and near-term performance. There are three types of market-based valuation methods:

1. Market Capitalization
2. Enterprise Value
3. Comparable transactions, and
4. Multiples of various fundamental financial measures

Market Capitalization

Market capitalization is based primarily on the product of Shares Outstanding and price per share; setting adjustments the product of Shares Outstanding and price per share; setting adjustments aside, as the name implies, there needs to be a ready market for the outstanding stock with recent price per share data. As such, this is primarily of use for valuing public companies.

For example, as of market close on Oct 19, 2020, Cintas Corporation per share was at $341.32. With 104.62 million shares outstanding, the company has a market capitalization of $35.71 billion. (Actually, according to Yahoo Finance, the market capitalization is $36.45 billion; the difference in part is due to intraday market prices trading about $8 per share higher as well as various adjustments.)

Enterprise Value

At its simplest, Enterprise Value (EV) is Market Capitalization + Debt – Cash.

As above, Market Capitalization equals total number of shares outstanding times per share price.

Debt includes both short and long term debt. Short term debt includes short term notes payable and all other payables, including trade, wages, leases and taxes.

And Cash includes cash equivalents, including treasury bills (T-Bills) and certificates of deposit (CD’s).

A more complicated formula also includes minority interest, preferred equity and unfunded pension liabilities.

Let’s stick with the simple case, since the most important takeaways for the typical business seller are, well, simple.

And there are two points to be made.

1. One, since EV requires an underlying market capitalization, the utility of EV is limited to the availability of such a market capitalization.
2. Two, nevertheless, buried in the formula are three issues to consider when preparing your company for sale.

First and foremost of these is the issue of debt.

Since debt adds to EV, taking on debt can actually work on your favor, assuming that the debt is productive debt. (Which begs the question: how much debt, as a multiple of EBITDA, is “okay”?)

Comparable transactions

Just like home sales, the trick is to find transactions that are comparable. As squishy as

home sale comparisons are, this task is made more difficult because there are so many more variables to consider. If a comparable transaction is obviously available, then use it while it is still timely. If not, there are simpler, more accurate approaches; like—multiples.

Multiples based Business Valuation

There are two parts to the multiples based business valuation:

1. The basis—which is what we will focus upon
2. The multiple or multiple applied to the basis—e.g., 3x, 5x, 7x and so on

The actual multiple varies by industry, among other factors. To keep pace, let’s focus on the three primary bases and their variations.

1. Book value
2. Sales revenue
3. Earnings

Book value

Book value, as described above, is the net asset value. In some industries, a multiple of book value is used to provide a quick business valuation. It is on the conservative end of the valuation scale—not really the seller’s best friend. Nevertheless, with it, you can get a quick, thumbnail valuation that is in line with your industry. Again, it provides a (hopefully) worst case scenario.

Sales revenue

Sales revenue is also a simple method as revenue or sales is typically readily available, even for a privately held company. Sales revenue is the value of products and services that the business sells. Though annual revenue is typically the basis, monthly recurring revenue (MRR) is used in some industries, such as security alarm services. Subject to negotiation is the treatment of one-time versus recurring sales revenue, contract versus non-contract revenue and various trade discounts and allowances.

Also important is how the revenue is classified. Different multiples are used depending on the industry. For instance, service revenue, regardless of industry, typically has a different multiple than resold or manufactured goods or installation / construction revenue as there are different underlying assumptions about gross and net profit. The times revenue multiplier for most industries — ignoring outliers — ranges between 0.5- and 3-times revenue. If your business has different types of revenue streams, you need to ensure the revenue is classified and valued properly — that is, to your advantage.

This wide range is due to the different profitability profiles of many different industries. And there is really no guarantee that the company itself is profitable regardless of sales revenue.

Although a business valuation might begin with discussions around a multiple of sales revenue, the larger and more complex the business, sooner than later, discussions will move to earnings.

Earnings based valuations, such as EBITDA

An earnings-based valuation requires up to date financial results prior to having a multiple applied for it.

Earnings are typically based on net income less preferred dividends (used primarily to derive Price-Earnings Ratio).

Then, one of various Earnings Before calculations, usually EBITDA – Earnings Before Interest, Taxes, Depreciation & Amortization – but also EBDIT, EBDT & EBIT, are used.

Seller’s Discretionary Earnings (SDE) is an alternative to EBITDA that is used when a buy/sell transaction assumes that the buyer will replace the seller in operating the business. According to the International Business Brokers Association, SDE are the earnings of a business prior to:

• Income taxes
• Nonrecurring income and expenses
• Nonoperating income and expenses
• Depreciation and amortization
• Interest expense or income
• “owner’s total compensation for one owner/operator, after adjusting the total compensation of all owners to market value.”

The Net-Net on multiples

The Multiple used is not constant—the applicable multiple for one industry might be 1-2 times EBITDA and 5-8 times EBITDA for another. Further, the multiples vary with the economic climate.

Here is where the market capitalization of public companies comes into play.

With a public company, we know the market capitalization or value, which again is primarily the share price multiplied by number of outstanding shares of stock.

Also, public data are numbers like annual sales revenue, earnings (primarily EBITDA) and book value.

With these bits of data, ratios are derived:

• Market Cap to Sales
• Market Cap to EBITDA
• Price Earnings Ratio
• Market Cap to Book Value

With these ratios in hand—for a comparable company, you can apply these to your own company’s financial data.

Understand that the multiples for public, comparable companies will fall in a range. And so, it is best to find at least three.

You may be tempted to cherry pick and pick the highest valuations. A buyer will be tempted likewise to find the low end of the range. You best be prepared.

While Asset-based valuations provide a baseline valuation, market-based valuations—especially earnings and revenue, separate the serious buyers and sellers from the looky-loos and delusional.

The smaller and simpler the transaction, the more likely a multiple of EBITDA or MRR will suffice to arrive at an agreed price. The larger and more complex the transaction, the more likely, sooner or later, you will be negotiating discounted cash flow forecasts and assumptions.

Discounted Cash Flow (Future / Forecast)

Discounted Cash Flow (DCF) method is the most complex. And arguably the most accurate as it typically incorporates elements such as historical book value, sales revenue and current earnings or profitability.

The method forecasts future cash flows over a period of years, applies a discount factor or factors to these cash flows, among other steps, to arrive at a business valuation.

Central to the DCF process is a spreadsheet model built with (your) historical financial data, forecasted revenue (in) and cost (out) cash flows and various critically important assumptions about the future, such as growth rates, interest rates, discount rates, tax rates and so forth.

The chief argument for a seller NOT creating their own DCF model is that it takes time and effort to do so. The argument being that the time and effort is better spent running the business rather than modeling the business.

I disagree.

The more sophisticated your buyer—for example, private equity and merger & acquisition groups within large, industry leading companies—the more likely the buyer will use a DCF based business valuation method.

The more sophisticated the prospective buyer, the more likely that they will have a Valuation Team — a.k.a., Devaluation Team — that will conduct a due diligence audit. They will most certainly have their own model.

Models as you know contain adjustable parameters and logical assumptions; absent your own model or an ability to tease out the reasonableness of these parameters and assumptions, you are negotiating on their terms from the outset.

Creating your own model beforehand can help you in subsequent negotiations:

1. Tailoring one to your business gives you a preview of the issues likely to surface during the negotiations. And, with a glimpse of the buyer’s likely thinking, to prepare accordingly.
2. Prioritize just what needs to be and can be done to improve the valuation – before negotiations start. In fact, well before you put your business up for sale.
3. Display professionalism and understanding of the business.

For example, let’s say businesses like yours are selling for 2-3 times EBITDA (see above). If your EBITDA is $400,000 then the negotiating range is $800,000 to $1.2 million. Their offer might be $900,000 and they have a DCF model which shows you just why $800,000 is a fair price.

Wouldn’t you rather be in a position to know that before they even make the offer?

Wouldn’t you rather be able to point to your model and show why $1.2 million is actually the fairer price?

While the multiple approach tells you to grow the basis (EBITDA or SDE), the DCF method, at the end of the day, shows you just where to focus on revenue growth and cost containment.

Next Steps

I promised 5 next steps. And here they are:

1. If only for your own eyes and benefit, think through why you want to sell your business, write this down and keep it with you.
2. Likewise, think through when you want to sell your business. Plan backwards from your desired sell date to today, noting each step you will take. Again, write this down and keep it handy.
3. Make a list of who might buy it. Write down how and when those conversations could start.
4. Decide whether to sell it on your own or with the help of a broker. Depending on the size of your business, one way is better than the other.
5. Take steps toward creating a DCF business valuation. Begin with a thumb nail business valuation.