One thing every business owner has in common is they want to grow their business. Your business is your most valuable asset. There comes a point when you want to know your business’s worth. It may be for estate planning, an IPO, bringing business partners or buying out a partner, selling your business or just curiosity to know the value of your life’s work.
Determining The Value Of Your Small Business
Now, how do you value your business? Is there a single formula for all types of business? What parameters make up the business value? As a business owner, you may always have a higher value for your business because it derives more value. But valuation is a price that is the fair market value that you can claim for your business.
The valuation is dynamic and changes according to the economic and market scenario. For instance, many businesses lost their value during the pandemic. So, the value you derive for your business is as of that date.
There are many ways to value a business, but three are the most widely used approaches.
In this article, we will discuss the three popular business valuation approaches.
The Market Method to Value a Small Business
As the name suggests, the market method takes the reference of a similar deal that was closed in the market to arrive at a value. This method is popularly used in real estate wherein the price of a house is determined by the selling price of a similar home in the same neighbourhood.
This method might look easy but is rarely used as the core methodology to arrive at a business value due to its various limitations. Firstly, finding a comparable business operating in the same industry, geographic location, and offering similar goods and services is difficult. There may be two restaurants on the same street, but one a fast food outlet and one a fine dining restaurant. They are not comparable.
Secondly, if you do find a comparable business, private companies are not required to disclose their information, leading to a lack of knowledge. And even if you get your hands on the price someone paid to acquire the business, that price may not be the actual value. The seller’s negotiation skills could influence the price, the buyer’s desperation, an act of compulsion, or financial strength (one company may have more debt than the other).
Despite these limitations, the market method can be a secondary approach to validate your business valuation.
The Earnings Method
The main objective of any business is to earn profits, so why not value it on its potential to generate future cash flows or earnings? The earnings method (also known as the income method) values the business on its potential to create future income. Many established companies use this method, which is ideal for asset-light businesses with commercial goodwill. Professional services like lawyers, doctors or fund managers don’t have a significant tangible asset. Their value lies in their skills and the client list that comes with them. Hence, the earnings method is ideal for them.
How To Determine Business Value in the Earnings Method
Under the earnings method, the accountant forecasts revenue, cash flow, and earnings from past results and discounts them for any risks to arrive at a rate (discount rate and multiple). There are two approaches to calculating the value using the earnings method.
- The discounted cash flow (DCF) method forecasts future cash flows and divides it with a discount rate to determine the present value. To arrive at the appropriate discount rate, consider the economic and market conditions company and industry-specific risk on the valuation date. So you start with the risk-free rate and add a premium for the economic and company risk.
- The capitalized earnings/cash flow method is the reverse of DCF. Instead of future cash flows, it normalizes the historical earnings/cash flows and multiplies them with a multiple. Here the multiple takes into consideration risks and market conditions. You multiply your cash flow/earnings with that multiple and then add or deduct assets and liabilities to arrive at an enterprise value.
The valuation you arrive at will be as of a particular date, subject to change with the change in circumstances.
The Asset Method
The third most popular method is the asset method which is ideal for an asset-heavy company like infrastructure, agriculture, mining or real estate. Such companies’ earnings may be less attractive, but they have significant value for their physical assets, goodwill, or brand.
You need not use just one method to value your business. In some instances, a business derives more value in pieces than the whole, depending on the buyer’s interest. For instance, a popular bakery may be located at a prime location. One buyer might be interested in the location, and the other in the recipe. A skilled accountant could mix multiple methods to arrive at the best valuation. The accountant could value your business using both asset and income methods and compare it with the market method.
Contact McCay Duff LLP in Ottawa to Help You Value Your Small Business
A professional accountant will study your business and the need for valuation and accordingly prepare a valuation report. At McCay Duff LLP, our accountants and consultants can provide forecasting and business valuation services. To learn more about how McCay Duff LLP can provide you with the best accounting expertise, contact us online or by telephone at 613-236-2360.