How to Value a Service Business: Methods, Key Factors & More
Unlike product-based businesses, service businesses can be more challenging to evaluate. How do you value intangible assets such as service quality? How do you factor in changes in industry trends?
In this guide, we discuss how to value a service business accurately and increase its worth.
At Exitwise, we are dedicated to helping you achieve the business exit of your dreams. We'll help you find the best M&A experts to value your business and sell it at the highest price possible.
Consult with our team today to evaluate your business correctly, improve its value, and sell at the most favorable terms.
Service Business Valuation Methods
Depending on the nature and data available, different methods can be used to determine the value of a service-based business.
We'll go over four ideal methods for a service business valuation:
1. SDE Method
The SDE or seller's discretionary earnings method uses both, internal and market considerations. The SDE is the full financial benefit you derive from the business as the owner-operator, including your salary and other benefits.
The method is ideal for valuing a service business run by the owner or in which the owner actively works, and the company is significantly dependent on them.
The market consideration comes in because you use external industry valuation multiples derived from the prices at which other similar businesses have sold in the past.
Here's a sample SDE valuation assuming your annual SDE is $230,000 and the market-derived multiple is 2.1x:
Business Value = SDE x Multiple
= $230,000 x 2.1 = $483,000
2. Asset-Based Method
The asset-based valuation approach is intrinsic, considering your business's assets and liabilities as per the formula:
Business Value = Total Assets - Net Liabilities
If your business has assets (such as intellectual property, office equipment, vehicles, or technology) amounting to $550,000 and liabilities amounting to $100,000, the value would be:
Business Value = $550,000 - $100,000 = $450,000
3. EBITDA Multiple Method
With the EBITDA multiple method, you can see how many times your business is worth its EBITDA. The method has an internal consideration (EBITDA) and an external aspect (market-derived EBITDA multiple).
The EBITDA multiple method is ideal if your service business makes $5M+ in annual revenue. Assuming an EBITDA of $5.5M and a multiple of 3.67x, here's what your business would be worth:
Business Value = EBITDA x Multiple
= $5,500,000 x 3.67 = $20,185,000
4. Discounted Cash Flow Method
If your business has predictable, stable future incomes, use the discounted cash flow method to show better your profitability capacity and ability to generate revenue.
An income-based approach, the DCF method uses the formula below:
DCF = CF₁ ÷ (1 + r)¹ + CF₂ ÷ (1 + r)² + … + CFₙ ÷ (1 + r)ⁿ
Where;
CF₁ = The first year’s cash flow
CF₂ = The second year’s cash flow
CFₙ = The additional projected cash flows
r = The market-derived discount rate
Here's a sample valuation:
Year one cash flow = $2,000,500
Year two cash flow = $2,300,500
Discount rate (r) = 3.5%
DCF = $2,000,500 ÷ (1 + 0.035)^1 + $2,300,500 ÷ (1 + 0.035)^2
= $1,932,850 + $2,147,541 = $4,080,391
Evidently, determining the value of your business can be overwhelming.
But don’t worry.
You can estimate the value using our free online business valuation calculator to obtain a preliminary value of your business's worth based on its revenue or EBITDA.
How to Value a Service Business
A service business valuation is much more than just calculations. Here are the steps to an accurate valuation:
1. Analyze Financial Health
Use your historical financial records to determine if you should sell your business based on its profitability, liquidity, or operating efficiency.
2. Consider Your Tangible and Intangible Assets
Service businesses can be tricky to value as most of their value could be tied to intangible rather than tangible assets.
Check the value and quality of office equipment, real estate, technology, and accounts receivable.
You should also determine the value of intangible assets such as brand reputation, intellectual property, and vendor relationships.
3. Assess All Liabilities
Determine your responsibilities, including long-term and short-term debt, taxes due, and wages payable.
4. Calculate Financial Metrics
Calculate all the possible financial metrics using the data available. Some key metrics include revenue, expenses, net profit, EBITDA, projected future cash flows, debt-to-equity ratio, and more.
The metrics come in handy when you calculate the value of your business, depending on the valuation methods you use.
5. Evaluate Growth Potential
You can consider your business’s growth potential, which a new owner can realize through strategic planning and improvement.
For example, is there room to expand your client base by opening new service locations?
6. Consider Industry Comparables
Market comparables are an excellent benchmark for valuation methods like discounted cash flow analysis.
You can compare your valuation to the values of other businesses or recent sale prices to determine whether it is accurate.
You'll want a valuation that reflects the prevailing valuation amounts and trends in the market to avoid underselling or outpricing your business.
7. Analyze Your Market Position
Consider your market standing in terms of customer base, competition, and the suitability of your business's geographic location.
Are there ways to improve your market position to command a better valuation?
8. Apply Valuation Methods and Make a Report
Use your preferred valuation methods to calculate the monetary worth of your business. The best way to value a business is to use different methods to act as benchmarks and checkpoints for each other.
Once done, write a comprehensive and objective business valuation report to show prospective buyers and your M&A team.
Speaking of an M&A team, the right experts can help you determine the best valuation using suitable methods. They can also compile a thorough report and guide you through it to help you understand your business’s value clearly.
At Exitwise, we connect you with top M&A lawyers, finance accountants, investment bankers, and wealth advisors to help you maximize your exit.
Reach out to our team today to recruit and work with the best industry-specific M&A experts for an accurate valuation and optimal exit.
Key Factors that Affect the Valuation of Your Service Business
The value of a service business depends on both internal and external factors, such as:
Revenue Growth: The ability to generate revenue is not enough on its own. You also need to consider your business's revenue growth. If it’s considerable year-over-year, you can expect a higher valuation.
Profitability: Your business may be generating revenue and experiencing consistent revenue growth, but is it making enough profits? If your costs are too high, your profits diminish, and the valuation lowers.
Customer Retention: Maintaining good customer retention can mean securing a higher valuation. You can retain more clients by adopting a customer-centric approach, improving customer engagement, and enhancing customer support.
Scalability: Scaling a service business can be tricky as it typically requires extra equipment and staff, which can be costly. If it's easy to find additional workers and equipment, your business can be easier to scale, and you could command a better valuation.
How to Improve the Value of Your Service Business
You can improve the value of your service business in various ways:
Optimize Your Customer Care Service: Quality customer care is key to service businesses, so yours must be top-notch. Focus on providing round-the-clock support and solving their concerns satisfactorily, both online and offline as applicable.
Raise the Standard of Your Actual Service: Ensure your staff delivers the highest quality of service based on their expertise, experience, and industry best practices. They should also personalize services to the specific needs of each client. Excellent service delivery can mean better customer retention, increasing your business's value.
Grow and Diversify Clientele: Use various tactics, like introducing a referral program, to increase the number of clients. You can also diversify your customer base by expanding into additional market segments, locations, or demographic groups. Your business’s value can increase as more clients indicate that you can easily boost revenue, diversify risk, and achieve growth targets.
Create New Revenue Streams: Adding relevant upsell or cross-sell services can help you provide a holistic customer experience and generate more revenue. Ensure the costs of the additional services do not exceed the revenue you realize from them.
Most Common Mistakes Made When Valuing a Service Business
Business valuations are an art and a science. You'll want to master both sides of the activity by avoiding common mistakes such as:
Using Only One Valuation Method: No single valuation method is ideal for every business. You'll want to use multiple methods to act as checkpoints or benchmarks for each other to ensure a more accurate valuation.
Overestimating Future Cash Flows: Overly optimistic projected cash flows that do not reflect your business's true capabilities can skew the valuation. Use historical performance, sensitivity analysis, and market analysis to make conservative projections.
Ignoring Liabilities: Disregarding liabilities, such as debt, can lead to an inflated valuation. Use debt analysis, including the impact of debt on future cash flows, to get a more accurate business valuation.
Disregarding Intangible Assets: Ignoring intellectual property, customer relationships, brand reputation, and other intangible assets can lead to undervaluation and underpricing.
Frequently Asked Questions (FAQs)
Here are some common questions to wrap up the discussion:
Can the Valuation of a Service Business Vary Based on Industry Trends?
Yes. The valuation of your service business can vary depending on industry trends.
For example, market volatility can reduce value due to lower demand as investors perceive businesses in that market as risky.
Similarly, reduced revenue and difficulty finding new customers due to increased competition can also lower your business's value.
When Should I Consider Hiring a Professional Appraiser to Value My Service Business?
Hiring a professional appraiser to evaluate your business should happen as soon as you decide.
Working with the right M&A experts is the best decision you can make when selling your business, as they can help you understand its value better and negotiate a favorable sale price.
What Are the Key Financial Metrics to Consider When Valuing a Service Business?
Some critical financial metrics to consider in a service business valuation include revenue, expenses, gross and net profit, debt-to-equity ratio, cash flow, and customer lifetime value.
Conclusion - How Do You Value a Service Business?
Even though valuing a service business can be tricky, you can get it right the first time now that you know the various internal and external considerations and the mistakes to avoid.
As mentioned, hiring the right professionals is the best way to make the valuation easier and more accurate. If you are looking to exit, these professionals can also help you sell faster at an appropriate price.
At Exitwise, we help you hire your dream M&A team to assist you with the valuation and exit. We can connect you with industry-specific M&A attorneys, wealth advisors, investment bankers, and finance accountants.
Chat with us today to find the best M&A experts to value your service business accurately and sell it at the best possible price.
