4 Ways to Calculate the Value of Your Company
We know the process of selling your company can be overwhelming, but our mission is to educate and prepare you as you enter this step of your entrepreneurial journey.
You see it in the news nearly every day—massive capital raises, highly-publicized M&A transactions, and unfathomable valuations or catastrophic down rounds.
There is so much talk about the magnitude of undeployed “dry powder” available in the capital markets. Companies are bought and sold for millions or billions at what seems like the drop of a hat.
If you’re a business owner, it’s tough not to think of your company. With every company that gets sold, you’re likely wondering: “How much is my company worth?”
My partners and I asked ourselves the same question when we thought about selling our businesses over the years. The truth is that there’s no one perfect, one-size-fits-all valuation methodology out there unless you speak with a M&A expert who specializes in selling companies of your size and in your industry.
That being said, when it comes to creating valuations for a private company, there are four popular and commonly accepted frameworks. Below, we outline how each of these concepts works in theory and highlight some of the strengths and pitfalls of each valuation method.
1. Earnings-Based Valuations:
The most common way to calculate the value of a company is by looking at past profitability and future earnings potential. Earnings-based valuation methods allow potential buyers to better forecast the potential risks and returns of purchasing a company, and are most suitable for stable, profitable businesses.
Earnings-based valuations are one of the simplest and most prolific valuation methods. Take a look at earnings over a specific time period (usually several years or more) and assume that future earnings growth will remain similar.
If you’re a smaller startup or new business with expected profitability in the near future, it’s a simple way to showcase your projected growth in a clean, easy-to-understand fashion.
But just because the formula is straightforward doesn’t mean it’s mindless—earnings-based valuations require a deep understanding of the business to justify the price tag.
The biggest downside of this valuation method? The assumptions used to derive an acceptable capitalization rate are imperfect.
If you’re looking for a more nuanced and complex analysis, you’ll need to understand the Net Present Value (NPV) of future cash flows/earnings and consider appropriate industry multiples.
2. Market Comparables
For businesses that sell specific products and have similar expenses in every location (e.g., franchises), calculating the value of the business is fairly straightforward.
But it’s a lot harder to use balance sheets and accounting to determine the fair value of service-based businesses, such as creative agencies, businesses in an emerging industry, or even specialty clinics.
For these types of businesses, market comparables (or “comps”) are usually more helpful and informative.
A sales-based comp valuation approach involves comparing a company’s revenues to those of a similar competitor that recently sold. A profit-based valuation approach looks at the profits of a similar company that recently sold instead.
Using this information, potential buyers can calculate an appropriate sale or revenue-based multiple. For example, if a competing specialty clinic had $5 million in revenue and sold for $15 million, the sales multiple is 3x. A similar specialty clinic making $4 million a year in revenue might sell for $12 million.
Of course, finding similar companies that recently sold is the hard part. In the private markets, this information can be very difficult to obtain. That’s one of the unique things we do at Exitwise.
3. Income-Based Valuations
While earnings and income may seem similar, they are very different from an accounting perspective. Both figures can be used in dramatically different ways when valuing a company.
“Earnings” refer to after-tax net income or profit, or “the bottom line” of the company (found on the Income Statement). “Income,” on the other hand, typically refers to gross income, or income after accounting for expenses related to producing goods or services.
The most popular income-based business valuation method is the discounted cash flow (DCF) valuation method.
A company’s DCF refers to its expected future cash flows. Calculating the DCF is a relatively simple way to determine the value of an investment today based on future projections (also known as the present value of expected future cash flows).
Generally speaking, from a potential buyer's perspective, if a company’s DCF value is above the cost of the acquisition, the investment could result in positive ROI.
4. Cost-based Valuations
A cost-based valuation is a very simple, somewhat effective way to quickly value a company. Using this method, a prospective buyer would consider the costs that went into the creation of the company, platform, or product. This type of valuation approach is commonly used when real estate values are a consideration in the transaction.
Instead of looking for the sales price (or profitability) of similar companies, the cost-based valuation approach values a business based on its “replacement value”—or what it would cost to build a look-alike business from scratch (also called a “build vs. buy” analysis).
Although seemingly straightforward, this method requires quite a bit of legwork. The potential buyer has to determine how much initial capital went into the company, as well as the value of any past or current assets fundamental to the company’s day-to-day operations.
The cost-based valuation method involves calculating “going concern” costs, an accounting term that refers to the expenditures required for a company to operate and grow indefinitely.
It’s also important to calculate the assumed value of any intangible assets that are required for the business to continue operating and growing on a company’s balance sheet.
Alternatively, the “book value” refers specifically to the money shareholders or buyers of the company would receive should the company be liquidated.
Selling a business doesn’t have to be a headache
At Exitwise, we know that selling a company can be overwhelming. That’s why our mission is to educate and prepare you as much as possible to help you decide if and when to sell your business.
From setting proper expectations around the value of your business to debunking misinformation surrounding the M&A process, we encourage you to take the necessary time to educate yourself on the exit process at Exitwise.com.
Feel free to lean on the help of your trusted advisors, accountants, attorneys and wealth managers. Then schedule a few minutes to speak with one of our exit experts, who are more than happy to walk you through a custom business valuation and answer any questions you might have.
With over two decades of collective experience helping business owners like you secure the exits they deserve, Exitwise is here to help. Our team of exit specialists will walk you through the step-by-step process of accurately valuing your business and helping you hire the best M&A experts for your specific business to help maximize your exit.