16 Nov What to Know About Business Valuation
Whether purchasing or selling a business, it is important to understand the common techniques used to determine the value of a company. This will allow an entrepreneur to achieve a better price for their business, or help an investor find a reasonable deal. An objective, bias-free approach will effectively price a company based on its key operational aspects. This is most commonly done through several methods: asset-based valuation, earnings multiplier valuation and fair market valuation.
Asset-based valuation considers the company’s assets – tangible and intangible – minus its liabilities. This is one of the most common methods, as its simplicity makes the method faster than other commonly accepted practices. However, this process lacks thoroughness, which is not ideal when valuing a company. It also loses effectiveness when the assets of a business belong to the owner, which is common with a sole proprietorship, as they typically use equipment or supplies for personal and business use. As such, the asset-based valuation method should be taken lightly when used on its own to determine the price of a company.
Asset-based valuation is best suited to assign value to a smaller company with a low projected revenue stream.
Earnings Multiplier Valuation
The earnings multiplier valuation is a favorite method of business analysts, as it measures the earning potential of a company to provide a clearer picture of the future return on investment (ROI). When this approach is used on a small business, it uses earnings before interest, taxes, depreciation and amortization (EBITDA) to determine the value. Once the EBITDA is calculated, a multiplier is used. This can range from one to over 10, depending on the individual company’s risk, location, industry comparisons, etc. For example, if a company’s EBITDA is valued at $500,000 and the multiplier was determined to be five, then the value of the business is $2,500,000.
The earnings multiplier valuation thrives when when the company has strong, consistent revenue streams.
Fair Market Valuation
Valuing a company by comparing it to its competition and other businesses in the industry, is what is known as a market value approach. Despite its popularity, it is a challenge to use for small businesses, as finding comparisons to create a baseline value is difficult. (Most small company acquisitions are not publicly available.)
Fair market valuation is best used when combined with other approaches to achieve a more complete, accurate assessment.
When an entrepreneur is considering selling their company, it is recommended that they are not heavily involved in its appraisal, as the significant amount of sentimental value will not factor into the valuation. Whether purchasing or selling a business, working with a qualified attorney, such as the professionals at Cole Sadkin, can help provide realistic, accurate valuations, while providing assistance to achieve the best price possible.