Valuing the assets of each business and totalling them. This isn’t always easy to ascertain. For instance, the value of the assets stated on a balance sheet (the book value) is rarely ever the true value of the assets in the relevant marketplaces. If a business is being liquidated and the assets must be sold by a specific date, then the book value is rarely ever an accurate metric to go by. However, if the assets can be sold over several months, then the value of the assets will be closer to their fair market value (FMV). In most cases, assets use this value because it’s a price that a reasonable buyer would be willing to pay when there is no pressure on either the buyer or seller.
Unless you are purchasing a business that is asset-intensive or losing money, the asset approach typically isn’t the best indicator of the true value of a business. As such, we don’t usually recommend this method unless the circumstances allow for it.
An income-based approach uses several methods to determine the value of a business based on the anticipated benefits of owning a business. In other words, an income-based approach determines the value of the anticipated income of a business. This can be an incredibly complicated subject to talk about, but most of the time, it involves what the current earnings and income streams of a business are.
To calculate income, most valuations will use the following methods:
Seller’s discretionary earnings (SDE) is a direct measurement of the bottom-line benefit of owning a business. It is calculated by summing the totals of the following:
- Owner compensation, profit sharing, salary sharing and so on paid to all the owners, less the salary of any employees needed to replace a 2nd or 3rd owner
- The employer portion of payroll taxes based on the salary of one owner
- Pretax net income
- Interest expense (business debt is typically a non-operating expense and assumed to be paid off at closing)
- Discretionary expenses or perks that are paid by the business in question. This can include the owner’s health insurance, personal travel arrangements, meals, entertainment and so on.
- Adjustments for non-recurring expenses or revenue. This includes lawsuit expenses, natural disaster recovery and discontinued products
The other method is earnings before interest, taxes, depreciation and amortization or EBITDA for short. This method is calculated in a similar method to SDE with one exception; it also includes compensation for management.
There are several areas of risk that should be kept in consideration depending on the buyer’s requirements and also the business itself. For instance, competitive forces, the barrier to entry, growth rates, current management and the size of the company are all factors that need to be considered as potential risk factors.
To give an example of risk, consider the following. If an investor invests in a portfolio of stocks that represents the entire stock market, a low percentage rate of return such as 7-8% will be seen as adequate return due to the diversification in the industry. However, someone that wants to purchase a retail store will look for a much higher rate of return due to the competition, employee turnover, lower barrier to entry and the supervision required. As such, it’s important to calculate risk separately depending on the business or industry that you are interested in.
Finally, a market-based approach will determine the value of a business by comparing it to other similar businesses in the industry that have been bought or sold. It’s not the most comprehensive method or a complete valuation, but there are several informative databases of sold businesses to give you a rough example of how much you can expect to pay for a business of similar size and influence.
Businesses are rarely ever the same as another, but grouping businesses with factors such as region and type can make the comparisons more relevant and a better metric for judging the value of a business. We subscribe to these databases and consult several sources for information. We use extensive sets of data to help us use a market-based approach more effectively and we also have our own database of sales to use as a reference point.
Opinion of Value
A broker’s opinion of value only utilizes market data to determine the approximate value of a transaction. It uses sets of sales data that have been recorded from thousands of transactions that are readily available in databases that we have access to. It’s a fantastic way to get a fair market value approximation of an ongoing business and we prepare these quotes in-house. It usually takes anywhere from three to five days to prepare an opinion of value once we have received all of the necessary documentation that allows us to make comparisons.
Valuations Prepared by Third-Party Firms
By mixing all of the approaches of valuing your business, a value analysis third-party valuation firm can help you determine the fair market value of your business. The report is intended to find the value of main street businesses with revenues under $1,000,000, or in simple, larger firms. The reports are typically around 40 pages long and they take around two weeks to complete. The report provides a full summary of how the valuation was determined.
Most main street businesses are bought and sold on a multiple of cash flow and the basis of this valuation is SDE.
The analysis considers factors such as your current financial strength and your history. Not much time is spent analyzing your balance sheet. Reports will contain the following:
- Historical Income Statement
- Adjusted Cash Flow Statement (SDE)
- Comparable Sales (Market Approach)
- Summary of Common Size Financial Statistics
- Summary Review of Each Valuation Approach
- Valuation Conclusion and Justification
The formal valuation is a limited scope business valuation that is designed for small businesses with sales between $1,000,000 and $5,000,000. Reports are between 50 to 70 pages and take roughly two weeks to complete. It provides a detailed review of all of the aspects that were considered in the valuation of the business. Much of the report will be focused on a financial analysis and the valuation conclusion is based more on the EBITDA instead of the SDE. It spends a lot of time detailing the current and future financial performance of the business in question. In addition to the income of the company, the balance sheet is a key component in the analysis.
- Historical Income Statement
- Adjusted Cash Flow Statement (SDE)
- Complete Financial Statement Analysis
- Common Size Analysis
- Ratio Analysis
- Economic Outlook Comparable Sales Detailed Description of Each Valuation Approach Considered & Used
- Valuation Conclusion
Merger and Acquisition Valuation
The merger and acquisition valuation is a comprehensive business valuation that is designed for transactional purposes. It is developed in accordance with the Uniform Standards of Professional Appraisal Practice. The valuation is intended for larger small businesses that have annual revenues that exceed $5,000,000, businesses that are expected to value of $1,000,000, strategic acquisitions of niche businesses and businesses with expectations of significant growth in the future.
The evaluation is based on future earnings with the historical performance taking a back seat in the calculations. The selection of companies that act as guidelines are chosen from both public and private markets, thus making the evaluation more conclusive. The report is highly customized and is roughly 80 pages long. Due to the greater detail, a merger and acquisition valuation takes around three to six weeks to produce.