When it comes to making smart decisions for a business, most owners and financial planners want to focus on business worth—and for good reason. Evaluating a business’s worth is important, not only to ensure that the business remains profitable and is meeting its financial goals, but also as a tool to consider whether the business should be sold and, if so, what that sale price should be.
Taking the time to evaluate a business's worth will shine some light on processes that can be improved as well. For example, if significant spending is undercutting a business’s profitability and severely impacting its worth, changes can be made in that area to address the issue and increase the cash flow. The changes required might mean cutting out unprofitable avenues of production or tightening the reins on spending to become smarter about what costs the business incurs.
But how is business worth calculated? Several approaches exist, and all are in some way valuable. However, some calculations are considered more reliable than others, and each should be considered together to understand the full picture of a business’s health and financial standing.
Discounted Cash Flow
The discounted cash flow model of business valuation works best for businesses with a consistent income. It uses historical data to make future projections. If a business’s profits vary widely from month to month, discounted cash flow is unlikely to be a reliable choice for evaluating worth and financial health.
“How much cash does the business generate currently, and how much will it continue to generate in the future?” This is the question that discounted cash flow seeks to answer. A business using this method will take historical data on earnings and project those into the future. It will then convert those future earnings back into today’s dollars (this is called the net present value).
Publicly Traded Comparables
One of the simplest ways to determine a business’s value is to compare it to other similar publicly traded companies. A business interested in pursuing this avenue of valuation often takes five to ten companies similar to it in revenue, size, and location and chooses a couple of metrics to measure from each company. The most commonly used metrics include price-earnings ratio and earnings before interest, tax, depreciation, and amortization (EBITDA), among others. Then, the average of these multiples is taken from among the sample comparable companies.
By examining how these metrics vary compared to other publicly traded companies, it becomes simpler to see how that business might be valued in the public market. However, lack of comparable businesses can make this method a challenge for some companies, particularly smaller businesses.
Transaction Comparables
Using data from transactions to compare companies is similar to the publicly traded comparison mentioned above. The difference is that the numbers analyzed are not profits or expenditures but rather transactions. If a business in the public sector has similar transactions as the business in question, they may be comparable not only in data but in value.
Book Value
Book value is one of the most common ways to examine a business’s worth. It is also often the least accurate, however. Nonetheless, it makes up an important part of any valuation examination.
This method is a real number cruncher, as it relies entirely on the balance sheet and hard value of assets and liabilities. For example, the value of a business in this scheme would be derived from totaling all assets and then subtracting all liabilities. Because there is a lack of nuance and comparison in this method, however, it is not always a reliable indicator of the true value of a company.
Seller’s Discretionary Earnings
For small businesses that may have a hard time comparing themselves to other players in the market, business worth examination may be particularly challenging. One way to overcome this obstacle is by using seller’s discretionary earnings to determine business worth.
Seller’s discretionary earnings are the pre-tax income of a business (gross income). This is not the same as what’s reported on an income tax return, however. Many businesses will use expense reporting and deductions to lower their tax burden on their actual tax return, which makes this newly reported number inaccurate for the sake of determining true value.
On top of the gross income, additional factors must be added back in to examine the business as it would be to a new buyer. These factors include expenses that aren’t necessary for running the business, such as charitable donations, perks that employees receive, and payroll of non-essential positions.
On top of this, add accounts receivable, cash on hand, and any real estate holdings, then subtract from this any business liabilities. This will generate the business’s estimated value.
Putting It All Together
Valuing a company and understanding what a business is actually worth can be a tricky process that varies widely across industries, locations, and sectors. Because of this, it’s best to use more than one valuation tactic to insure that a wide spectrum of data is considered. Using several valuation methods will ensure that the results will be more robust and accurate. Estimating a business’s value by projecting the earnings of the best month ever into the next ten years might look exciting, but it’s hardly realistic and may undercut smart business decisions.
Take some time to identify business multipliers based on sector or industry as well as the average of important data vectors in comparable businesses to determine how a particular business might be valued. Some companies consult on business valuation, and relying on professional assistance with this process may not be a bad choice either.