Business Valuation 101

Show/Hide Info

I would imagine that the reason you are watching this, is that you are considering either now, or some time in the future, selling or buying a business. Understanding the factors that determine the value of any business, will pay tangible dividends whether you intend to sell or buy a business.

If selling, such understanding will help one focus on ways to increase one’s business’s short and long-term profitability. This in turn, will assist one in positioning one’s business for sale to receive the highest price.

Similarly, if considering the purchase of a business, such knowledge will ensure that the value of the business is truly understood thereby affording one the best opportunity for a successful purchase.

So a good place to start might be to understand what a Business Valuation is.

A business valuation is defined by Wiki as “a process, and a set of procedures used to estimate the economic value of an owner’s interest in a business”. Note that the definition included some key words such as “process” “estimated” , “Economic Value” and “owners interest”. A meaningful evaluation therefore needs to be based on a set of procedures and through a valuation process that reflects the economic value of an owner’s interest in the business. A meaningful valuation is not derived at, through simple multiples. Multiples almost never reflect the true value of a specific company, but rather reflect the median or average of a specific industry or distribution group as it’s known in statistics.

There is a pseudo-science, or an art if you would, that provides the foundation for skilled business analysts and appraisers to estimate what a business is worth. This is often viewed as a “black box.” Resulting in a mythology around valuation of private businesses. To help de-mystify the valuation process, I first want to identify a few myths about valuing private business so that you can avoid the pitfalls these myths present.

Valuing a private business should only be done when the business is ready to be sold.

Knowing the value of ones business, will assist one in determining the relationship between an owner’s expected value, vs. a market reality value, and affording one the ability to properly plan for growth and maximum value.

If a business is to have a life beyond that of its current owner, then realistic knowledge of value, and effective planning for ownership transition requires a regular valuation of one’s business.

Here is another one.

Businesses in my industry always sell for X times annual revenue or X times earnings so why should I pay someone to value my business?

The short answer is that as stated previously, these are simply erroneous numbers, reflective of industry or transaction medians without consideration to the subject company’s specific performance, efficiency and many other valuation factors. In a previous episode of the Pacific Video Blog Tim Quarles demystifies multiples and encourage you to watch it in order to learn more about multiples.

I am sure most of you have heard something like this:

Joe Doe with a similar business sold it for three times revenue or X times earnings just last year.

My business is worth at least this much!

Maybe yes, and maybe no.

What happened last year is not really relevant to what something is worth today.

What ones business is worth today is largely dependent on various factors including:

  1. How much does the business generate today?
  2. How much cash can the business generate in the future?
  3. How predictable and sustainable are those cash flow earnings; and
  4. What is a buyer’s, required return on their investment in your business, based on relevant risk and time factors?
  5. Additionally, there are many value drivers that one needs to consider.

The value of a business is its fair market value. The International Business Brokers Association defines FMV as that price paid for a business by a willing buyer to a willing seller when each is fully informed and neither is under pressure to act. The value of ones business however, may or may not be reflected in the transacting price. So price and value are not necessarily congruent, since value is perceived and driven by assumptions and perception, while price is a reality, driven by the market and compulsion.

Though we often say that if a business is not making money then what are we selling, it can also be stated that another myth could be that one’s business financials show it losing money so it is not worth much. Most private businesses appear to lose money. Appearances, however, are often misleading and you may want to check out our “Investing in Taxes” video blog for some additional insight on the subject. Unlike public companies, the separation between ownership and management does not really exist in a private business and so, owners and or their accountants may reflect various levels of discretion over how much money the enterprise is generating, since the more they show, the more taxes they will need to pay. Recasting or normalizing the financials to reflect the true earnings of a business is a critical activity to accurately reflect the value of a business for purchase or sale purpose.

There are many value drivers that one should also consider beyond just the numbers when valuing a business for purchase or sale.

In the final analysis, there are many important reasons that a business owner should know the value of his or her businesses long before a decision is made to sell it.

By understanding the basics, one can successfully plan one’s financial future by understanding the value of ones’ most important asset. The Business.