If you know the actual fair market value of your business, then you are in possession of a very valuable tool. Some pundits go so far as to say that business valuation is one of the most important concepts in finance. While that might be debatable, there is no question that every business owner should have a good handle on the worth of their company.
A business valuation is a powerful tool that considers where your company has been, its status today, and most importantly, its future prospects. A valuation is defined as the price that a reasonable person would pay to own the future cash flows of a business, minus any existing debt, plus all cash on hand.
The goal of getting a business valuation is to obtain a current estimated economic or fair market value of the business. It is a good idea to hire a professional appraiser for a variety of reasons, including: calculation of estate and gift taxes, shareholder and partnership buyouts, marital dissolution, buy-sell agreements, bankruptcy, commercial or project financing, or financial and tax reporting.
A valuation can also be used as a powerful driver of how to manage a business. It can help track the effectiveness of strategic decision-making processes, and provide the ability to track performance in terms of estimated change in value, not just revenue. With a rash of baby boomers retiring on the near-term horizon, a business valuation is particularly important in any type of business transfer, regardless of the size of the company.
There are numerous ways to value your business, each with its own particular complexities. The three most-used methods are the discounted cash flow method, the market multiple method, and the capitalization of earnings method. Regardless of the method you choose, you will need accurate financial statements for several years, as well as cash flows, capitalization, real estate appraisals, industry comparables, and total cost of equity.
Discounted Cash Flow Method
When using the discounted cash flow method, the business’ future cash flows are estimated and their worth today is determined. Once the cash flows have been estimated and an appropriate discount rate determined – based on a reasonable rate of risk-adjusted return expected on those cash flows – present value will be used to calculate the value of the cash flows. More simply stated, what would you pay today for a dollar that will be given to you at some point in the future? The farther out you project cash flow, the more heavily it is discounted, as uncertainty increases with every additional year. From that number, you once again subtract all debt, then add in cash to reach the fair market value of your business.
Market Multiple Method
Another way to value a business is by using the market multiple method, which involves fewer complicated calculations. With this method, similar businesses that have been sold recently are studied, and the selling price is compared to a designated business metric, such as revenues or earnings.
Let’s say you own a retail store and you would like to determine its value. You know that a store similar to yours in the area recently sold for $1 million, and had $200,000 in earnings. The market multiple for this business is calculated by taking the sales price of $1 million and dividing it by the earnings of $200,000. The market multiple here is five times earnings. If you extrapolate this out to your business, you would simply multiply your business’ earnings by five, subtract debt, and then add in cash.
Which Method is Best?
There are benefits and drawbacks to all three methods. Although the discounted cash flow method is complicated, it captures the specific story of your business, and more importantly, the direction in which you think it’s headed. The problem is the difficulty in accurately predicting the future and in determining a reasonable rate of return for your business.
The market multiple, or comparable sales approach, on the other hand, is handy because it estimates well what people are actually paying when buying a business. It does not take into account the specifics of your company, however, such as your unique cost structure, and it is not forward-looking.
With the capitalization of earnings approach, you start with annual earnings for one or more years, then divide earnings by a “cap rate” that reflects the cost of capital and the company’s risk. For example, say a company has average annual earnings of $200,000 and a “cap” (capitalization) rate of 10%. Dividing earnings by the cap rate ($200,000/10%) results in an estimated valuation of $2 million.
Conclusion
A business valuation will capture an enormous amount of information about your business in one easy-to-understand number. Once its value is determined, the business can be sold, publicly traded, or financing can be obtained. Knowing fair market value will enable you to sell your business for its actual worth, and keep your heirs from paying more than they should in estate taxes.
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