Whether you’re planning to sell your business or looking to acquire one, determining the best valuation formula can be one of the most difficult parts of the process. The challenge is not without significance; accurately valuing a business can be the difference between a successful transaction and a failure.
So, what’s the best business valuation formula? It depends. There are numerous methods that can be used to assess a business’s value. The best formula depends on a number of factors, including industry, assets, and size of the business.
Here’s a breakdown of the some the most common and useful formulas for valuing small- to medium-sized private businesses:
- Asset-based. Calculates a valuation based on the value of salable assets.
- Calculates a valuation based on the value of assets if a company went out of business and needed to be sold quickly.
- Multiplier and “rule of thumb.” Calculates a valuation based on a multiple of earnings or enterprise value, often using widely accepted multipliers within an industry.
- Comparable sales. Calculates a valuation based on comparable businesses or previous transactions.
Let’s take a closer look at these valuation categories.
The asset-based approach uses a company’s net asset value or the value of its assets minus its liabilities. While this method seems simple, it’s not necessarily as easy as adding up the value of the assets on a company’s balance sheet. Sometimes, the asset-based approach requires more art than science because some assets, such as proprietary products and strategies or intellectual property, have intangible value and may not appear outwardly on the balance sheet.
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However, an asset-based valuation method can be particularly useful when a company is operating at a loss but still holds valuable assets, such as investments or real estate. These assets are relatively easy to value and can be used to arrive at an appropriate valuation for the business.
A company’s liquidation value represents the total worth of a company or entity if it were to go out of business. Unlike an asset-based valuation, it excludes intangible assets and only focuses on assets that can be sold on short notice. The method can be useful when dealing with businesses in bankruptcy.
Multiplier method and “rules of thumb”
It’s not uncommon to hear of a company selling for “x times earnings.” Typically, this refers to use of the multiplier method, which uses a multiple of annual earnings, or income, to determine the value of a business. This method is generally used when expenses are predictable and not expected to fluctuate dramatically.
Most industries have common standards for what multiple to use, also called “rules of thumb”, which provide a starting point for negotiation. For example, manufacturing businesses are typically valued at four to five times earnings plus any inventory on hand. While “rules of thumb” are popular methods for valuing small businesses, they eliminate any intangible value built into the operation.
These closely related valuation methods rely on regional and industry data to value a business. The comparable sales method requires finding recently sold businesses in the same industry and geographic area and benchmarking a price based on that data. While a similar approach is common in the real estate market, it can be problematic for valuing small businesses because they vary so widely.
Are you ready to sell your business? Before taking steps, it’s beneficial to speak with a business broker or mergers and acquisitions (M&A) advisor to help determine the right method or discuss more complex scenarios. Market share, intellectual property, and proprietary products can all add value to a business but such information isn’t always available on a balance sheet.
Bruce Hakutizwi is the U.S. and international manager of BusinessesForSale.com, a global online marketplace for buying and selling small- and medium-sized businesses. With more than 60,000 business listings, it attracts 1.4 million buyers every month.