Valuing your Business - a Simple Method
Posted by Tom Gledhill on Fri, Jun 10, 2011 @ 01:40 PM
In a previous article we discussed the 1st step in the business sales process – ANALYZE THE COMPANY. In this article we’re going to discuss determining an approximate VALUE for your business.
There are about 9 methods of valuing a business that professional appraisers use. Most of them are used for special situations mainly in larger companies.
You only need 1 method to ballpark the value of a business. Before we get into details, let’s discuss some valuation fundamentals.
Valuing a business is mostly about RISK & CASH FLOW. The higher the CASH FLOW, the higher the value; the lower the RISK, the higher the value.
Expressed as an equation: VALUE = CASH FLOW/RISK.
Value is directly proportional to CASH FLOW and indirectly proportional to RISK.
What is CASH FLOW? In smaller companies (revenues <$3 million) we use Sellers Discretionary Earnings (SDE).
SDE = Net Operating Income + Owners Salary + Adjustments.
Adjustments are any expenses taken that are not absolutely necessary to the operation of the business. Examples of adjustments are auto expenses, meals & entertainment, depreciation, excess salary, non-recurring expenses, etc.
The adjustment must be reasonable and verifiable - Too many adjustments can raise a red flag.
Now that we’ve determined the CASH FLOW, we need to determine the RISK.
In a previous article – ANALYZE COMPANY – we examined aspects of the business that affected value – these are the things that affect RISK.
In the eyes of a prospective buyer the company’s performance should be transferrable and sustainable. If the business can’t function without you, then the business is not transferrable or sustainable.
The simple equation that we use for ballparking value is:
VALUE = SDE * MULTIPLIER
The multiplier represents the degree of risk and is typically between 1.5 and 3 for smaller companies (<$3 Million). The lower the number, the higher the risk.
Now that you have estimated RISK from an analysis of your company and determined your company’s SDE, you’re ready to determine an approximation of your company’s value.
Larger companies (revenues >$3 million) use EBITDA instead of SDE. EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization.
EBITDA is simply SDE minus a reasonable owner’s salary. The multiplier using EBITDA is usually between 3 and 5.
In this Article we’ve just scratched the surface of business valuation. In no way does it take the place of a professional valuation. But it should give you an appreciation of some valuation fundamentals and also a method of ballparking your company’s value.
To view the video of this article click Value your Business