What is the value of a business?
Valuing a business should not be put off to the last minute when a business is looking for an exit. Most business and finance professionals agree keeping valuation numbers current is a good idea. Using valuation as a measurable key performance indicator (KPI) allows the owner to continuously make changes that maximize value. Valuing a business frequently provides the owner several additional insights such as whether selling the business will provide sufficient funds to retire or whether merging a business is a better option to selling the business.
Overall, there are several reasons to value a business where buying or selling a business is the most important one. Reasons to value a business can be summarized as:
- Keeping score of value created
- Making changes continuously to maximize value
- Facilitate business merger or sale
- Division of assets within a family and estate planning
- Tax planning and other disputes
- Keep track of valuation for retirement
Valuating small businesses is tricky because there is no central database that keeps track of all transactions. Therefore, valuing a business requires a lot of work and information. Both business buyers and business sellers need to value businesses. The business seller usually has completed valuation and has a price. Regardless of the business seller’s price, the buyer must independently value the business as well. Usually the business buyer will value the business a price that is lower than the asking price. If the two valuations are in the zone of probable agreement (ZOPA) then there is room to negotiate and potentially close the deal.
Collecting this information for a business valuation starts from understanding the industry to conducting detailed financial analysis of the company’s financial statements. For industry analysis the evaluator must determine if the industry is growing or declining and how well the business is positioned within the industry. The evaluator must also complete competitive analysis using Porter’s five force analysis. Other elements of due – diligence includes quantifying the addressable market and current market share of the business.
There are several valuation methods one can use to determine the intrinsic value of a company. These valuation techniques are broadly classified as Asset value methods, Earnings value methods and Market Value based methods. The valuation methods listed above are based on discounting future cash flow, discounting future earnings and using industry specific multipliers. Corporate financial statements including the tax returns are the best source for intrinsic valuation and buyers should ask for at-least five years of data before valuing businesses.
Companies should enlist valuation experts for business valuation. Valuation experts can also help business owner’s benchmark against industry best practices and performance. Experts in business valuation fall in one of the following areas:
- Business brokers
- Certified appraisers and valuation experts
- Forensic accountants
- Attorneys and lawyers
Business owners tend to resist getting their business valued by a professional because of the cost involved. So, while it is important for business professionals to learn how to continuously value their business informally and they must also value their business formally.
What are the methods of Biz. valuation?
Businesses exist to make a profit for their Shareholders. Profit is also known as income or earnings for large-cap public companies. There are three terms that represent the concept of profit and it is critical small businesses understand the difference. Profit or earnings can be expressed as Net Income, EBITDA (Earnings before Income Taxes and Depreciation) and SDE (Seller Discretionary Earnings).
Net Income also known as bottom-line is the most commonly used metric to quantify profit for middle market and large cap companies. It can be easily found on the Income Statement. However, Net Income (NI) provides a skewed picture for small business that may be owner operated. Typically, small businesses want to reduce taxes, so they maximize expenses to reduce their EBIT (Earnings before Interest and Taxes). As such, Net Income is not a good metric for small businesses.
Another metric for profit commonly used by large and middle market companies and private equity groups is EBITDA. Private equity groups like to use EBITDA because it is a quick approximation of the businesses operating cash flow. EBITDA is also useful for larger businesses because it expenses the management and operations. Private equity groups do not get involved in day to day management of the company, so it is important to factor in management cost. The rationale that makes EBITDA good for mid to large companies is what makes it bad for small businesses, where the owner expenses must be added back to EBITDA get a true picture for earnings.
Seller's Discretionary Earnings (SDE) is the mostly widely used metric for small business valuation. SDE represents the earnings of a small business more accurately because it makes adjustments for owner operator expenses. The simplest way to conceptualize SDE calculation is by taking the EBITDA and recasting owner expenses. Owner’s expenses must include owner’s salary, bonus and all benefits. The technique may be used to roughly estimate the SDE for a small business. Conversely, one can conceptually go from SDE to EBITDA by subtracting owner’s expenses. So, EDITDA = SDE – (Owner’s Salary + Benefits) and SDE = EBITDA + (Owner’s Salary + Benefits). Seller's Discretionary Earnings (SDE) is also sometimes called Seller's Discretionary cash flow.
There are several techniques to business valuation including asset based methods, earnings based methods and market based methods. Rule of thumb based valuation of a business is typically a multiple of SDE or EBIT. The multiplier for your business depends upon several factors including sector, industry, location, deal-size, deal structure, economic climate, financing, number of buyers and so on.
Please note / Disclaimer: Business owners must work with a business professional such as a business broker or chartered accountant (CA) to get an exact estimate for their business. The techniques described here is for business owners to conceptually understand Seller's Discretionary Earnings (SDE), which plays a critical role in business valuation.
How are intangible assets valued?
Intangible assets are assets that are not physical but have legal rights attached to them and create value for the owner. They sometimes make up a very large component of a business but are not factored into intrinsic valuation of the business. A lot of value is created out of the accounting system and intangibles assets could account to as much as 80% of the intrinsic value of a business in some cases. As important as intangible assets are, business owners usually do not have a clear understanding of these assets. While rule of thumb valuation techniques factor in some of these benefits, valuing intangible assets and then adding it to the intrinsic valuation should be the preferred approach to valuing a business.
The time spent in planning, marketing, human capital, building relationships and developing a corporate culture are expensed on the income statement to calculate net income or net profit. While this is appropriate and required from an accounting point of view, cumulative investment in areas like developing an agile and customer focused corporate culture must be identified recognized as intangible assets.
Intangible capital of a business usually falls in the following areas:
- Brand value which is the Net Present Value (NPV) of the estimated future cash flows attributable to the Brand. A strong brand is a distinct asset owned by a business and can be easily monetized by keeping prices higher than the competition.
- Systems of differentiation developed by the business to compete in its marketplace.
- Customer relationships which includes a loyal customer base and loyalty systems. Businesses should leverage concepts such as customer acquisition cost (CAC) and life time value (LTV) of a customer to value its customer base.
- Business Processes related to customers acquisition including paid and unpaid activities.
- Internal Business Processes and technical expertise.
- Favorable location for the business.
- Patents, Copyrights, Trademarks, Trade names, Non-compete agreements and R&D.
- Relationships with partners including supply chain related business processes.
- Supply agreements, Licensing agreements, Service contracts and Franchise agreements.
- Unique corporate culture and corporate reputation.
When a buyer, seller or investor is conducting due-diligence on a company, he/ she must value at intangible assets in addition to calculating the intrinsic value of the business. All parties must be aware of all intangibles and know if the company has low intrinsic valuation with high intangible assets or vice versa. That said there may be an arbitrage opportunity if one party recognizes an intangible asset that the other party has discounted or not identified. Understanding intangibles also provides a view into the health of an organization.
The process of valuing intangible assets starts with first identifying and listing all intangible assets, which requires thorough understanding of the business. The next step is to attach a fair value to each intangible asset and to estimate the economic life of each intangible asset. Finally, businesses can get a value by using the company’s discount rate to calculate the present value of all intangible assets listed.
Other approaches to factor intangibles into the value of a business are to add a premium to the intrinsic value of the business. The magnitude of the premium will depend on the industry and the sector. Alternatively, a few intangible assets like patents can be added as assets to the balance sheet as long as it allowed by the accounting standards.
What is rule of thumb for valuing a business?
Discounted free cash flow (DCF) and earnings excess based valuation techniques are the fundamental to correctly valuing businesses. That said businesses can also use rules of thumb to quickly value their businesses. Using rules of thumb is a great approach to get a quick and dirty estimate before conducting deeper financial analysis.
Rule-of-thumb valuation is a guideline that businesses owners and business brokers use for a particular industry or line of business to value a company. There are rules available for almost every type and size of business in existence. Most of these rules are based upon multiples of an economic benefit such as earnings, cash flow or annual revenue. Check with your industry associations for rule of thumb formulas for buying or selling a business.
Some examples of rules-of-thumb used to value businesses are:
- Accounting firms are valued at 100-125% of annual revenue
- Dry Cleaners are valued 2-3 times adjusted cash-flow or 70%-100% of annual revenue/li>
- Gourmet coffee shops are valued at 40% of annual sales + inventory
- Food shops are valued at 30% of annual sales + inventory
- Gas Stations (w/o C-Store) are valued at 15–20% of annual sales + inventory
- Law Practices are valued at 90–100% of annuals revenues
- Restaurants (Full-Serve) are valued at 30–35% of annuals sales + inventory
- Insurance Agencies are valued at 125–150% of annual revenues
- Grocery Store (Supermarket) are valued at 15% of annuals sales + inventory