You can value a business in many different ways, but if you’re thinking about selling your enterprise, you’ll probably want an idea of how much you may receive from selling it. This is useful for marketing and planning goals.
Fortunately, many sellers gravitate to one of four primary methods to value their business. They evaluate either: asset valuations, price-to-earnings ratios, discounted cash flow, and entry costs.
We’ll go through each of these in detail below, as well as the related calculations, as this can help you figure out how much you can sell your company for.
Before we begin, remember that you should always think about the factors and assets which may affect these calculations, as some may have a large effect on the value of your business (see also 'How Is A Small Business Valued? [Selling Your Business 101]').
Valuation Elements
It doesn’t matter what type of valuation method you go for, as you will need to take one or several of your company's factors and assets into account.
There are various elements you need to consider when valuing your company, like intangible and tangible assets which are more difficult to quantify. Examples include reputation, an intangible asset, and machinery, a tangible one.
Businesses are very varied according to the way they are run and the things they offer. Some of these factors may not apply to your business, but always check thoroughly before you start, as it’s important to make sure that you don’t overlook any assets.
Here are some assets that you need to take into account:
- Number and quality of workers
- Structures and buildings
- Equipment and machinery
- Land
- Stock
- Type of service or product
- Reputation, like social media followers
- Time in the company and track record
- Client value
- Intellectual property and trademarks
Valuation Methods
We’ll go over the four primary valuation methods in detail below.
1. Price To Earnings Ratios
This is the most common method used to value a business, you may also hear to called the multiple of earnings or capitalization rate. It’s thought to be the best choice for companies with strong profits, as this can denote an impressive forecasted growth and track record of recurrent business.
The methods used to achieve the correct price-to-earnings number differ from each other, while the numbers are usually from two to five for smaller business (and up to the hundreds for tech companies!). Looking on the stock market you'll see this ratio everywhere.
Calculation
Pricing your business is easy after you’ve worked out your price-to-earnings ratio. Simply multiply the post-tax profits by the ratio. But how do you work out the ratio for an unlisted company that doesn't have a "share price"? For that we need to rearrange the formula a little.
For instance, if a company had a price-to-earnings ratio of four and after-tax profits of $500,000, its price would be $2 million.
Rearranging this we can see that $500,000/$2,000,000 = 25%. Easy enough. Expressed another way would be to divide the PE ratio by 1. For example the PE ratio is 4. 1/4 = 25%. If the PE ratio was 2, it would be 1/2 = 50%
What does all this mean? This percent means the return on purchase. If you invest $2 million to buy this business and make a $500,000 profit you've made a 25% return.
Using this method you can see the return (and the inherent risk) a buyer would want. If there is less risk, then the return is lower, so the PE ratio is higher. If the risk is high, then the return needs to be higher to compensate for this risk, so the PE ratio needs to be lower.
2. Entry Costs
The idea of entry costs is like the phrase sounds, the cost of starting your company from scratch if you ever begin again.
Like you would with all valuations, it’s crucial to consider the factors and assets you need to take into account, as this makes sure that you don’t sell your business for less money.
This may incorporate tangible assets, like machinery, equipment upgrades, and machinery, as well as different start-up costs, like development, training, design, marketing, and recruitment.
Calculation
It’s generally easy to price your company with the entry cost method, but you need to make sure that you consider all of the relevant factors if you were to start the company up from scratch.
This process is highly individualized, as you will need to think about all the things you have invested and purchased to come to this point.
Despite this, you also need to consider any savings that might have come from using updated services, current technology, or using a different area that may knock the costs down.
Take away these savings from the entry cost figure to determine an ideal price for your business.
3. Asset Valuation
This method is often used for stable, firm companies that have plenty of tangible assets, like machinery or property.
To work out this value, you need to figure out what your business’s Net Book Value is. This involves any assets which are incorporated into the business’s accounts.
Remember, you also need to account for any economic influences that affect the assets, like a spike in value from more demand, or a decrease in value as time goes on.
Asset valuation can lead to you receiving a lower value for your company, it can be useful for companies with a lot of assets. You can also use this as ‘cold asset value’, as this performs as a rationale for market valuation.
Calculation
It’s generally easy to calculate asset valuation. Just work out your Netbook Value, subtract any lost value, then use the final numbers as the price.
For instance, if all of your assets bring your Net Book Value to $2 million, but your older machinery means the asset has depreciated to $200,000 from $400,000, you would take away the loss from the figure. This would give you a final value of $1.8 million.
4. Discounted Cash Flow
This valuation method is quite complex, and practically solely used by concrete, bigger enterprises, like energy companies which can anticipate cash flow.
Discounted cash flow involves estimating what your subsequent cash flow may be worth in the present, as well as any dividends predicted for the future and residual value as the period ends.
The discounted rate would be used to work out how much every future cash flow would be worth today. This makes sure that you consider the risk and how much the money is worth in real time.
Discounted rates can differ between 15-25%. Essentially, this method depends on the cash flow that will be accessible by new owners.
However, the primary problem with this process is working out cash flow that needs to be discounted, especially when working with complicated investments. It’s also harder to use this method if you can’t acquire future cash flows.
Calculation
Working out how much your business is worth with the discounted cash flow method is very difficult. Nevertheless, you can use an equation that can make the method a little easier.
The equation is:
DCF = (CF/(1+r)^1) + (CF/(1+r)^2) + (CF/(1+r)^3 + … + (CF/(1+r)^n)
The equation uses the following terms:
CF is the cash flow - the cash payments obtained by investors
r is the discount rate - this is generally the WACC (Weighted Average Cost of Capital)
n is the year number or period - generally five years
The Bottom Line
Overall, how much you can sell your company for is based on how much the business is first worth, as well as the different business valuation methods that can help you determine how much your company is worth overall.
If you have invested a lot of time and effort in your business, watching it develop over many years of hard work, you may have an emotional attachment to it that cannot be priced.
This is understandable, but if you want to establish the best feasible price for your company that’s free from emotional ties, you can use one of the four primary valuation methods above.
Whether you use discounted cash flow, price-to-earnings ratio, entry costs, or asset valuations, your chosen method should help you work out a respectable and reasoned sales number.