“How much is my company worth?” is a question that many business owners would like the answer to, and rightfully so, because the value of a business is one of the key factors that determines your business’ selling price. The most common methods to value a small to medium-sized business are the income approach, market and asset approach, and discounted cash flow (DCF). If the explanations detailed below are overly technical and if there are some terms used that you do not fully understand, check out the blog from last week “Key Financial and Accounting Terms Explained”.
Market and Asset Approach
This methodology is based on the principle of substitution, which means that a buyer will pay no more than the price required to purchase an equally desirable substitute. This method is designed to determine commonalities between companies by comparing key financial and business characteristics. There are two ways to go about this: if it was a franchise that is being valued then the cost to start-up another franchise is calculated, and if this is not the case then an assessment of comparable companies is made.
To compare the company against a similar franchise, the valuation is determined by considering the franchise fee, required inventory, leaseholds, royalties, invested capital (i.e. computers, furniture, machinery, equipment, etc.), and additional start-up costs (i.e. marketing, staffing costs, utilities, etc.). However, since the company that is being valued is already and established one, on top of the comparable franchise estimated start-up costs it is necessary to account for the projected sales, cash flow, and excess working capital that the company has already established.
If there is not a similar franchise to compare the company against, it is necessary to then compare it against similar existing companies within the industry. The typical business factors that are considered are products or services, industry, location, distribution channels, as well as customers and end markets. The usual financial factors that are considered are size, profitability, growth possibilities, return on investment, and credit profile.
Discounted Cash Flow (DCF)
DCF is the most popular method of valuation, and it is based upon the intrinsic value of a company, rather than the market value of a company. This is because it requires the valuator to thoroughly research, understand, and analyze the key valuation and forecast variables (both internal and external) that affect the business that is being valued.
DCF analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential of a company. If the net present value arrived at through DCF analysis is higher than the initial capital expenditure of the investment, the opportunity will yield a net benefit.
Despite the complexity of the calculations involved, the purpose of this type analysis is to estimate the money that would be received from an investment and to adjust for the time value of money. DCF is merely a mechanical valuation tool and small changes in inputs can result in large changes in the value of a company.
Instead of trying to project the cash flows indefinitely, the future free cash flows are usually calculated for 3-5 years depending upon the industry, and a terminal value is also calculated and included in the valuation to account for the value of the company at the end of forecast timeframe.
The Income Approach is based on the principle of economic value reflecting anticipated future benefits. This methodology has several components including market capitalization analysis which takes into account financial ratios and statistics including SDE (Seller’s Discretionary Earnings), Gross Profit (Sales – COGS), and EBITDA (Earnings before Interest, Taxation, Depreciation, and Amortization).
The company’s most recent annual cash flow is usually the best indicator of the current business performance. However, in order to create the most accurate and realistic projection for a potential new owner, a weighted Sales, Gross Profit, SDE, and Projected SDE based on a company’s historical and proforma Income Statements are created.
Furthermore, to get the most accurate valuation for the company, industry specific formulas, multiples, and performance metrics are taken into account for these calculations.,/p>
While these methods are very important in helping determine what your business will sell for, it is important to note that there other factors at play that can increase or decrease the final price that you receive, such as market forces, and the willingness of the buyer and seller to complete the transaction.
Furthermore, these explanations are a brief outline of the methods involved, and the actual modeling that is done to determine the value of a business is a considerably more involved process.