How much is your business worth? It’s a question a surprising number of business owners don’t know the answer to. we get it; if you don’t plan on selling, then the value of your business can feel like your take-home income plus the pride you have in what you’ve built.
Knowing the value of your business is important for reasons we’re about to go over in detail; We recommend getting a professional valuation, but this article will give you the tools to try it yourself. You might not get the most accurate results, but you will get a deeper appreciation of how different valuations lead to different values, and how much your business might be worth if you put it on the market today.
Why Business Valuation Matters Before You Sell
Look, if you’re trying to sell your business and you don’t know how much it’s worth, you’re putting yourself at serious risk of getting ripped off. We don’t want you to get ripped off, and you don’t want to get ripped off; that’s why we wrote this article.
Whether you’re planning your business exit ten years in advance or you’re planning to retire as soon as humanly possible, you want to know how much your business is worth; it keeps you open to opportunities and closed to exploitation. Let’s dive in:
3 Common Business Valuation Methods
1. Asset-Based Valuation
Asset-based valuation is a deceptively simple way of determining the value of a business; we say deceptively simple because, as with just about everything related to business sales, the devil is in the details.
Here’s how it works: You take the tangible and intangible assets of your business, you subtract your liabilities, and you end up with the value of your business.
The problem with this oversimplified look at asset-based valuation is that it fails to account for depreciation. The value of your assets on your books is unlikely to reflect their actual market value, unless you’re pretty extreme about your bookkeeping.
Another problem is how to accurately evaluate intangible assets like goodwill. These intangibles are possible to assess, but their value might differ from buyer to buyer; some buyers might want to rebrand your business entirely!
2. Earnings Multiple (SDE / EBITDA)
Earnings multiple valuation is a term for any valuation system that multiplies the earnings of a business by a figure known as the multiple. There are two commonly used systems that rely on multiples:
- Seller’s Discretionary Earnings (SDE)
- Earnings Before Taxes, Interest, Depreciation, and Amortization (EBITDA)
Clear as dishwater, right? To make things a little less murky, let’s start by looking at the multiple.
The multiple is just the number that you multiply your earnings by; SDE and EBITDA are two ways of determining your earnings. There are several factors that influence the multiple, including:
- Your industry (and the going multiple for businesses like yours)
- Growth trends
- Your customer base (diverse or concentrated)
- Your supplier base (diverse or concentrated)
- The size of your business
- Owner dependence (higher dependence on an owner means a lower multiple)
- Your revenue (stable revenue is better, unpredictable revenue hurts multiples)
Multiples typically range from 1x-10x, depending on these and other factors.
Now that you understand the multiple (hopefully), you need to understand how SDE and EBITDA are calculated:
- SDE is (Net Profit + Owner’s Salary + Owner’s Perks + Non-Recurring Expenses + Interest + Taxes + Depreciation + Amortization)
- EBITDA is (Net Profit + Interest + Taxes + Depreciation + Amortization)
Add the multiple to those calculations, and you have your business valuation.
These formulas mean that a business valued using SDE is almost always going to have a higher valuation than one valued using EBITDA. You might be asking: Why not just use SDE to boost the value of your business?
We’ll get to that in the next section, but here is a hint: If your business is big enough, no one is going to look at your salary unless you’re paying yourself an enormous amount.
3. Discounted Cash Flow (DCF)
Discounted cash flow (DCF) might be the most complicated valuation method to understand; if you have a large business, however, it’s also one of the most useful methods of valuation. Here’s how it might work:
- You start by coming up with a baseline; it might be a normalized SDE or EBITDA from the past few years (though there are several other ways of calculating the baseline).
- Once you’ve got your baseline, you make an assumption about growth. You can use growth trends over the past few years, industry growth, and more to make your assumptions.
- Growth isn’t free, so you’ll want to adjust your estimated cash flow by expenditures. Look at equipment that’s depreciating beyond its useful lifespan, how many employees you’ll need to hire, renegotiating contracts with suppliers, and other potential expenditures.
Once you’ve got your values (usually for 3-5 years after the acquisition of the business), you establish a discount rate. Much like multiples, your discount rate will vary based on a number of factors - basically the same factors as multiples, but in reverse:
- A highly concentrated customer base would decrease your multiple; the same concentrated base would increase the discount rate.
- Consistent recurring revenue would increase your multiple and decrease your discount rate.
With a discount rate established (ranging from 10%-30% aren’t uncommon, depending on the business in question), you plug everything into the following formula:
Discounted Cash Flow (DCF) = [CF1/(1+r)1] + [CF2/(1+r)2]...
Where CF1 is the estimated cash flow for year one, CF2 is the estimated cash flow for year 2, and r is the discount rate. Continue to calculate for future years, typically up to year 5.
Beyond that, most DCF models include something called terminal value; it helps estimate future cash flows beyond the forecast period.
That was a lot of math; determining discount rates and future cash flows is one of the reasons it’s so important to work with mergers and acquisitions experts in order to value a business.
Which Valuation Method Is Right For Your Business?
We will keep this section short and sweet after all the talk of math formulas and cash flow estimates:
- Choose asset-based value if your business isn’t doing well or if your assets are the most valuable part of your business.
- Choose SDE if you’re a small business owner whose personal compensation is likely to be a selling point.
- Choose EBITDA if the business can run reasonably well without the owner, and financials are standardized - usually mid-sized businesses.
- Choose DCF if you’ve got a big business with predictable cash flows and a lot of growth.
This is pretty generic advice because I don’t know who you are; the advice I give here has to be generic. Want to know which valuation system is best for your business? Call me. I’ll tell you.
Common Mistakes Business Owners Make When Valuing Their Company
The biggest mistake a business owner can make is trying to value their company without any expertise. You might choose the wrong earnings multiple, improperly value your assets, or make terrible predictions about growth. Not an expert in valuing businesses? Don’t try to do it on your own.
Business owners might also choose the wrong system for valuing their business, overvalue their business to try to make more money, or undervalue their business to try to make a quick sale. Don’t make any of these mistakes. Call me instead.
How A Professional Business Valuation Works
When we start working together to value your business, we are going to need quite a bit of information. Looking at your business model, your revenue streams, your liabilities, your assets, and more, I’m going to determine:
- How we should value your business
- What multiples or discount rates should be applied
- What your forecasted revenues look like
Once we have all of this information - which we will gather through the documents you send us, conversations with you, and our knowledge of what businesses that are similar to yours are selling for - We will come up with a valuation that accurately reflects your business.
This doesn’t mean that we’ll list your business at the valuation price; it’s for our own records and our own ability to negotiate with potential buyers.
Get A Clear Picture Of What Your Business Is Worth
The team here at Catchfire has a few ways of helping you determine the value of your business:
- You can talk to an expert (myself included) to get a business valuation.
- You can get a Ready-To-Sell Assessment to see how well prepared your business is for a sale, what it’s worth today, and what you can do to increase the value of your business to potential buyers.
We highly recommend calling us; the information we have provided here is rock solid, but it’s generic. To figure out the value of your business - and the best time to sell - we need to get specific. The only way to do that is to gather a lot of information about your business, and the only way we can do that is if you call me! Whether you’re looking to sell a business in Winnipeg today or in Montreal in a decade, we can help.