For a number of reasons I’ve had to discuss / review business values. Based on that, I thought I’d discuss business valuation in more detail. Let’s start with the most common valuation method which is the earnings valuation method.
The Basic Calculation
The basic calculation was calculated as follows – net assets multiplied by the earnings multiplier. Or written out:
(Assets – Liabilities) + (Profit x Earnings Multiplier) = Business Value
Things however get complicated for a number of reasons.
Assets for most e-commerce businesses include the stock, furniture, website and the accounts receivable amounts.
Note, however that things can get complicated if the company has decided to purchase assets like furniture outright or has already applied depreciation. In addition, you’ve got t o assess the value of a website which can be tricky.
Goodwill theoretically should be there. but Goodwill is often disregarded in cases like this.
Liabilities are generally easier to do. You have Loans and Accounts Payable to worry about, but not much else.. Shareholder loans can be tricky as you need to assess what the loan requirements are – many companies have a substantial shareholder loan but no documentation attached to it.
Profits at first seem pretty simple – just take the Net Profit right? However, it’s more complicated than that. When selling, you want to include things like the Owner’s draw and discretionary expenses (Add Backs) that might have been taken out of the Net Profit that are not necessary to the running of the business.
Often, especially with smaller companies; a number of discretionary expenses are added to lower the tax burden. These costs shouldn’t be part of the actual profit and thus, the sale price.
How about the profit multiplier? Well, this is tricky. The multiplier can be as low as 1 and as high as 10 depending on the industry and the growth (expected or historical) of the company. This is a harder number to find though business brokers or business sites like BizBuySell, etc can be a good place to start. Generally, multipliers of 2 to 3 are quite common for profitable businesses.
Are there other factors to take into account? Yes, a ton.
- Growth potential of the company can drive up the profit multiplier
- A history of profitable earnings can increase you general profit, not to mention your profit multiplier (if it’s shown to continually increase as well)
- Documentation and processes – a well documented business with policies & procedures that make it turnkey can significantly increase the value of a company
- Seller financing (i.e. you being willing to be paid out from the profits) can increase the value of the company
- Market share / ease of entrance into marketplace. If you are in an industry that is hard to enter and/or have a substantial market share (i.e. market leader); you can often command a higher premium for the company
Other Valuation Methods
Lastly, let’s talk other valuation methods:
- Book value (what’s it worth on paper?)
- Liquidation value (great if the company is liquidated and/or not an on-going concern)
- Debt-paying ability / Free cash flow (how much free cash does the company provide, thus allowing the business to be bought for that value)
- Capitilzation of earnings (basically, figuring out the return the buyer can expect)
- Revenue multiple (for high growth companies, this could be viable if they are not making any profits).
At the end of the day, there are a ton of methods of valuing a company. It’s worth noting why a company is being sold too – if you approach a company ‘blind’; unless the owner was intending to sell the company; you are likely to pay a premium compared to one that is actively looking for a buyer.