Probably one of the most common questions business owners ask is “How much is my business worth?” Maybe you want to do some retirement planning, estate planning, divorce planning, estate planning, etc. However, this simple question does not have a simple answer. Qualifications differ depending on their purpose. For example, courts and accountants focus on “Fair Market Value” without compulsion. For the sale of a business, brokers and appraisal experts create a “Most Likely Sale Price” that takes current market conditions into account. Suppose we are looking to sell our business and we want a valuation.
There are three main approaches to determining the most likely sale price:
1) Market approach
2) Income approach
3) Asset approach
The market approach is based on comparing “similar” businesses that have sold compared to ours, and then projecting a value for their business. The substitution principle would suggest that this is a reasonable way to arrive at a valuation. There are various issues such as comparing companies in different parts of the country, or even declaring, that can make this comparison inaccurate as local economic conditions vary. Additionally, comparing companies of significantly different sizes can skew results, as buyers often pay higher multiples for larger companies.
The income approach takes a perspective that assumes that a business is a cash-generating machine, and you should compare your business to any other cash-generating investment. The big difference here is that small businesses are risky, so you need to factor in an adjustment for risk. A key part of the process is identifying cash coming from the business through a process known as recasting. The recast will take tax returns or financial reports and estimate the cash flow of the business that benefits the owner. This is often referred to as “Seller Discretionary Cash Flow” (SDCF) or “Seller Discretionary Earnings” (SDE), or something similar. This cash flow number is then multiplied by industry-specific ratios to estimate a value. Other variations on this method include a capitalization rate applied to the SDCF or looking ahead and estimating the SDCF over several years and calculating the net present value of that cash flow (what the sum of future benefits is worth today).
Finally, the asset approach depends on the fair market value of the company’s assets. This is sometimes called the cost approach, since it deals with the company’s physical assets and does not provide much value for goodwill. In most businesses, goodwill is the bulk of the value of the business. This approach is most useful for unprofitable businesses or businesses that have a significant investment in equipment or other assets.
Ultimately, the market determines the price of the business. Because each business is unique, expect some negotiation on price. Buyers buy the whole package, it’s not just the price, but the perceived risk of the business, the prestige of owning that business, the volatility of earnings, the strength of the industry, the local economy, and a host of other factors that are not They are easy to quantify. The value opinion is the beginning of the discussion about what the business will actually sell for. You should get help when it’s time to price your business.