By Dan Miller, CFP®
Whether you’re thinking about retiring, selling your business, purchasing another or somewhere in between, a business valuation is the first step to determining the value of a business. Preparing for a business valuation isn’t complicated, but the calculations to determine the value of your business can be, and you want to make sure it's not undervalued.
This guide will help you prepare for a business valuation by exploring valuation options and the additional steps required to receive an accurate price. Let’s start by looking at the different evaluation methods.
Choosing An Evaluation Method
There are five business valuation methods available to small business owners. These methods include:1
- Adjusted net asset
- Capitalization of cash flow
- Discounted cash flow
- Market-based valuation
- Seller’s discretionary earnings
Adjusted Net Asset
The adjusted net asset is determined by subtracting liabilities from assets while using industry knowledge to adjust both metrics for current value. For example, an asset or liability may be priced lower than its original value due to market fluctuations, therefore adjusting the overall value of the business.
Capitalization of Cash Flow
This is determined by dividing your cash flow from your business’s rate of return. Cash flow is an amount of money that entered and exited your business within a given time.2 Your rate of return, or capitalization rate, is the earnings a buyer can expect to receive.
Discounted Cash Flow
Discounted cash flow refers to a complex process used to calculate the value of a business based on its potential growth.
Using this method, similar businesses that have been recently sold are examined to determine the value of your business.
Seller’s Discretionary Earnings
This valuation method is typically only performed on small businesses. It is calculated by subtracting long-term business costs from pre-tax and pre-interest earnings to determine how much money a business makes.
Establishing a Valuation Plan
Whether you know which valuation method you want to use or not, determining a plan can make the process smoother. Some valuations can be performed on your own. However, for business owners seeking more complex methods, professional assistance may be required.
Consider contacting an advisor, appraiser or another financial professional to help guide the process and make sure your business is given an appropriate value.
Organizing Your Documents
Valuation methods draw on a business’s documentation to calculate its final value. Collect the documents necessary for your chosen method, as well as any additional forms, contracts, vendors, etc. Each record will help determine the overall value of your business.
Calculating Intangible Assets
Up to this point, certain documents and assets could be considered tangible, or physical, assets.3 For example, an office could be considered a tangible asset. We often think of tangible assets first when considering business value, though intangible assets should not be forgotten.
According to the Corporate Finance Institute, intangible assets are non-monetary, identifiable and abstract benefits.4 As an example, an email list could be considered an intangible asset. It is beneficial because it contains the contact information for current and potential clients, possibly leading to more revenue. But, it’s not a physical object and does not hold a determined price.
Other intangible assets could include employee satisfaction or high SEO rankings; think of these assets as unquantifiable benefits.1
Whether you are looking to retire and sell your business, purchasing a new one or somewhere in between, consult this list to help plan your valuation process. And, when you are ready, contact a financial advisor or other financial professional to determine your plan of action.