How to Value a Small Business (Step-by-Step Process)
The term “small business valuation” frequently arises when owners consider attracting investors, negotiating an M&A, or planning for succession. However, a successful business sale heavily depends on an in-depth understanding of the company's value. Whether you are liquidating or selling to a new owner, an accurate valuation matters most for a mutually beneficial deal.
Do not worry. In this blog, we will walk you through a step-by-step process of determining your firm's value, giving you valuable insights for more informed decision-making.
TL;DR - How to Determine the Value of a Small Business
Today, we will discuss four key steps to calculate the accurate value of your small business, which are as follows:
Step 1: Evaluate your company’s assets
Step 2: Factor in intangible assets
Step 3: Perform a financial analysis
Step 4: Research your competitors in the industry
Are you ready to explore your business exit options? Exitwise can help you through a successful and profitable business sale. Schedule a call with our team today to get started and hire the best M&A experts.
What is Company Valuation?
Company valuation is the process of evaluating a business's worth by analyzing many factors, mainly used by owners planning to exit the company.
These include tangible assets like equipment, inventory, and real estate, as well as intangible aspects like forecast earnings, management structure, and stock price. Business owners can use valuation for different purposes, such as:
Selling their company,
Acquiring loans,
Attracting investors, and more.
However, aside from monetary value, business valuation is integral in resolving issues stemming from divorce settlements, estate taxation, and shareholder disagreements. In legal cases, courts may appoint forensic accountants to perform independent valuations.
Key Terms and Concepts in Business Valuation
Wondering how to calculate the valuation of your business? Here’s a list of key terms and concepts you should know before you start assessing your company value:
Key term | What does it stand for? |
|---|---|
Book Value | A company's accounting-based value is calculated by subtracting total assets from total liabilities. It shows the company's net worth according to its financial statements. |
Fair Market Value (FMV) | The real value of a business is based on a hypothetical transaction between a willing buyer and seller, where both parties are aware of the business's conditions. |
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) | A measure of a company's operating performance that excludes non-operating costs such as interest, taxes, and depreciation. |
Discounted Cash Flow (DCF) | A valuation approach that calculates a company's future cash flows and discounts them to its current value. |
Capitalization Rate (Cap Rate) | Estimated by dividing a property's net operating income by its market value. A higher cap rate usually signals more risk and/or a lower expected return. |
The Multiples Method | It is a valuation technique that compares a business's financial metrics (e.g., EBITDA, sales, or income) to competitors or industry averages. |
Market Capitalization | It refers to the total dollar market value of a business's outstanding stock, calculated by multiplying the total volume of outstanding shares by the current market price per share. |
Goodwill | Refers to non-identifiable assets like brand reputation, client relationships, and intellectual property. |
Liquidation Value | The expected amount that is collected if all of a business's assets are sold separately and its liabilities are satisfied (often less than the market or book value). |
Net Present Value (NPV) | A method in discounted cash flow (DCF) valuation that calculates the present-day value of future cash flows minus the initial investment cost. |
Tangible/Intangible Assets | Physical assets like machinery, buildings, and land are tangible assets. Non-physical assets, aka intangible assets, include patents, trademarks, and goodwill. |
Leveraged Buyout (LBO) Valuation | A technique for borrowing a large amount of money (bonds or loans) to pay for the acquisition of another company. |
Minority Discount | A decline in the value of a minority ownership interest in a company is caused by a lack of control and marketability associated with minority stock. |
The Control Premium | Refers to the amount a buyer is ready to pay over the current market price for a controlling stake in a company. |
Due Diligence | An in-depth evaluation of a business, carried out by a prospective buyer, mostly to establish its assets and liabilities and appraise its commercial potential. |
Small Business Valuation Methods
If you're planning to sell your company or secure an M&A, here are some methods to calculate the value of your business:
1. Income-Based Approach
The income approach to business valuation focuses on a company's projected revenue in the future. It calculates the worth of a business based on the predicted future income. It uses two common methods:
Discounted Cash Flow (DCF) Method: This method calculates the present value of a company's future cash flow and is often used for newer businesses with significant growth potential but may not yet be profitable.
Capitalization of Earnings Method: Here, you calculate a company's value based on its projected future profitability, assuming a consistent rate of return over time. It is commonly used for established organizations with steady earnings since it simplifies the valuation process.
2. Asset-Based Approach
Adjusted Net Asset method finds the difference between a company's assets (adjusted to fair market value) and its liabilities. This strategy is notably effective for businesses with large investments or real estate and those who are unprofitable or considering dissolution.
To do an asset-based valuation, you must first list your assets and assign them a monetary value. This value gives you a good idea of the company's material worth.
3. Market-Based Approach
This approach calculates a company's value by evaluating the purchase and sale prices of competitors in the same industry. A comparative analysis can offer significant insights into the appropriate selling or buying price.
Moreover, a market-based approach is particularly beneficial for fast-growing businesses and industries where market trends and valuations can change quickly.
How to Determine the Value of a Small Business
As we’ve learned, small business valuation is a complex process requiring a diverse strategy. Though there are various approaches, the following key steps offer a strong starting point:
Step 1: Evaluate Your Company’s Assets
First things first, focus on the company's tangible and intangible assets. You can derive a rough approximation of the company's value by subtracting liabilities from assets.
Step 2: Factor in Intangible Assets
Intangible assets such as brand reputation, client loyalty, and intellectual property symbolize a significant portion of a company’s overall value, often contributing to long-term sustainability and competitive advantage in the market.
So, look at your company's unique characteristics and how they contribute to its value.
Step 3: Perform a Financial Analysis
Analyze your financial statements, including your balance sheet and income statement, in detail to understand your business’s financial standing. Some other metrics you can track are:
Seller discretionary earnings (SDE)
Earnings before interest, taxes, depreciation, and amortization (EBITDA).
Step 4: Research Your Competitors in the Industry
Comparing your company to similar companies in terms of size, industry, and revenue can help you better understand its market value.
Note: Every business is unique, so direct comparisons may not always be accurate.
Factors That Can Affect the Value of Your Small Business
Apart from EBITDA, here are four common factors that influence a small business valuation:
YoY Growth in Revenue: A steady increase in revenue shows a business is doing well and has bright prospects.
Profit Margin: Higher profit margins suggest that a company effectively manages its expenses and earns more per dollar of revenue.
Industry Concentration: A highly concentrated industry may restrict pricing power and diminish profit margins.
Customer Concentration: A high customer concentration can be risky for a firm because losing a key customer can significantly impact sales and profit.
Exitwise Hires the Right M&A Expert for Your Business
It's not easy to accurately value a small business for a profitable exit. Exitwise is dedicated to guiding you confidently and clearly through this path. Our team of exit professionals has helped countless business owners successfully exit over time.
We realize that every company is unique, so our strategy is customized to meet your needs. We're here to help you prepare for a seamless and successful exit, from accurate business valuation to connecting you with top M&A professionals.
So why wait? Schedule a call with our team at Exitwise today to start creating the exit strategy you deserve.
Frequently Asked Questions (FAQs)
Here are some of the most frequently asked questions about determining the value of a small business:
How Can a Business Valuation Professional Assist in Determining the Value of a Small Business?
A business valuation professional, such as a certified public accountant (CPA) with valuation experience or a company appraiser, can be extremely useful in estimating the value of a small business.
Our team of M&A experts has the expertise and skills to evaluate various valuation methods, such as asset-based, market-based, and income-based approaches. To arrive at an accurate valuation, our experts can collect necessary data, examine your company's financial health, and consider industry-specific aspects.
Let Exitwise guide you through the process, ensuring a smooth and profitable exit. Schedule a call with us today.
How Much Does A Small Business Valuation Cost?
The cost of a small business valuation may vary depending on multiple factors, such as the size and complexity of your business, the valuation methods used, and the level of data necessary. While it is difficult to provide an exact amount, getting quotes from industry-leading professionals can help you get an idea.
How Does the Industry Impact the Valuation of a Company?
The industry in which a company operates can greatly influence its worth, as it may have specific methods or factors. For example, IT businesses can be valued based on their growth potential and market share, whereas manufacturing businesses can be assessed primarily based on their asset base and profitability.
What Are Common Multiples Used in Small Business Valuation?
Some common multiples used in small business valuation are:
Price-to-earnings (P/E) ratio: It compares a company's stock price to its earnings per share.
Price-to-sales (P/S) ratio: This metric compares a company's stock price to its total revenue.
Enterprise value-to-EBITDA (EV/EBITDA) ratio: It compares a company's enterprise value (market capitalization + debt minus cash) to its EBITDA.
Conclusion
By following the step-by-step instructions in this blog, you can get an in-depth grasp of the key valuation methods and their relevance to your company. Remember to collaborate with an accredited business valuation specialist, such as Exitwise, to get accurate and reliable results.
With over two decades of experience advising business owners, we'll guide you through the valuation process and link you with top M&A professionals specializing in your business needs. Book a call with us at Exitwise today to get started!
