Your business is likely your largest asset so it’s normal to want to know what it is worth. The problem is business valuation is a “subjective science”. The science part is what people learn with an MBA or professional credentials. The subjective part is that every buyer’s circumstances are different, and therefore two buyers could see the same set of company financials and offer vastly different amounts to buy the business.
There are three commonly used methods for valuing a business:
The most basic way to value a business is to consider the value of its hard assets minus its debts. Imagine a landscaping company with trucks and gardening equipment. These hard assets have value, which can be calculated by estimating the resale value of the equipment.
This valuation often renders the lowest value because it does not account for “Good Will” or the difference between what someone is willing to pay for your company (market value) and the value of net assets (subtracting liabilities).
Discounted Cash Flow
In this method, the acquirer is estimating what your future cash flow stream is worth to them today. Once the buyer has an estimate of how much profit you’re likely to make in the forseeable future, and what your business will be worth when they want to sell it in the future, the buyer will apply a “discount rate” that takes into consideration the time value of money. The discount rate is determined by the acquirer’s cost of capital and how risky they perceive your business to be. The key components of this method is based on 1) how much your business is expected to make in the future and 2) how reliable those estimates are.
Another common valuation technique is to look at the value of comparable companies that have sold recently or for whom their value is public. The problem with this method is that it often leads owners to expect the same valuation as much larger, public companies. Small companies are typically deeply discounted when compared to their Fortune 500 counterparts.
Finally, the worst part about selling your business is that you don’t get to decide which methodology the acquirer chooses. If a strategic buyer is interested in your company, then a different valuation may be used because your business fits their future growth strategy. This situation usually yields the highest value.