One of the central business valuation techniques under the income approach is the discounted cash flow method. It lets you calculate the business value based on three fundamentals:

• Business earnings forecast, usually annual cash flows.
• Discount rate which captures business risk.
• Long-term business value, known as the terminal value.

The standard discounting valuation formula assumes that the business cash flows occur at the end of each year. However, a business may generate a smooth income stream throughout the year.

Mid-year convention adjustment

The typical way to handle such situations is to discount the cash flows as if they occurred in the middle of the year. This calls for just one simple adjustment to your discounted cash flow valuation result, multiplication by this factor:

where D is the firm’s discount rate. You can calculate the equity discount rate by using the Build-Up model. If the company is financed by both debt and equity capital, use the weighted average cost of capital (WACC) iterative procedure.

Example: Comparing discounted cash flow valuations with and without the mid-year convention.

Consider a company with the following cash flow forecast:

Let us assume that the firm’s discount rate is 30%. The estimated long-term earnings growth rate is 5.53% which gives us the business terminal value of $5,124,129.

With these inputs prepared, we next calculate the present value of the business using the standard discounting and then adjusting the result for the mid-year convention as follows:

Business value, standard discounted cash flow method

Business value adjusted for the mid-year convention

The mid-year convention result gives the business value that is 14% higher than the standard discounting valuation.

The difference grows as the discount rate increases. This makes sense – the more risky the business, the greater the importance of receiving the cash flows as early as possible.

It is a standing joke in the business appraisal profession: the business valuation is out of date the moment it is delivered to the client.

Business valuation has an expiration date

In fact, a key assumption for any business valuation is the date on which it is done. Why is the date so important? Here are a few key reasons:

• Business earnings prospects and the risk it faces change over time, sometimes very significantly.
• The industry sector can undergo changes that directly affect the value of firms competing in it. Major factors are industry consolidation, new government regulations, new and disruptive technologies.
• Investor expectations of return and perception of risk vary over time.
• Investor appetite for acquisitions can change. This in turn affects the market value of businesses. If you pay attention to the public capital markets, you will see how valuation multiples change as investors respond to market conditions.
• Access to capital for firms of certain size or in a specific market can have a great effect on their value.

Whether you conduct a business valuation for a client or assess the value of your own company, the business earnings outlook and risk evaluation are critical to your business appraisal result.

Refresh your business valuation as key assumptions change

Since none of us have a crystal ball, regularly repeated business valuation is essential. It helps you review your earlier assumptions and see what the company is worth at any given time.

Such a review will usually help you identify critical changes in these valuation parameters:

• Revised valuation multiples that reflect the current market conditions for the subject business.
• Discount and capitalization rates that you should be using to value your company.
• Realistic earnings forecasts that are the basis of business valuation, especially when you use the income-based methods such as the Discounted Cash Flow.

When the market uncertainty is especially high, you may want to consider a number of scenarios, each with its own assessment of business earnings outlook and risk. You can then use these scenarios as inputs into your business valuation calculations.

An average of the results, or a range of business values you calculate give you a well considered estimate of what the business is worth – and how business value has changed over time.

Business valuation tools that help you stay current

To make the task of business value reassessment easier, ValuAdder business valuation software is continuously updated to reflect the latest changes in the market:

The valuation multiples in the Market Comps Tool reflect the current values of companies similar to yours.

The discount and capitalization rates let you capture business risk that accurately reflects the current market trends.

Of all the business valuation methods under the income approach the discounted cash flow technique truly stands out. What makes this method unique?

Its solid financial foundation, flexibility in valuing established companies and startups, businesses with steady earnings and rapidly changing profits make this method an excellent choice for appraising all types of businesses.

Earnings and risk define business value

Best of all, the discounted cash flow method lets you focus on the unique value-creating attributes of each business and show clearly the key relationship among these fundamentals:

• Business value
• Business earnings prospects
• Business risk

How business value depends on your assumptions: what-if valuation scenarios

You can create business earnings forecasts of arbitrary length, usually measured in years. Each forecast is your vision of a possible business outcome. And each outcome is associated with a certain level of business risk, captured by the discount rate. The discounted cash flow method lets you determine the business value in present day dollars for each earnings and risk scenario.

To increase the accuracy of your business valuation, consider using a number of such scenarios. For example, construct earnings forecasts and assess company risk for:

• Base case, or most likely outcome you expect going foreward.
• Best case, when the business conditions are most favorable.
• Worst case, in case the business encounters unexpected difficulties.

You can then calculate business value as a weighted average of the valuation results you get for each scenario. The weights represent the probabilities, in your judgment, of each scenario actually occurring.

Discounted cash flow valuation as a decision making tool

The power of the discounted cash flow method is that it enables you to translate expected business performance into value. This creates a number of opportunities:

• Selecting the best financial and operational plan from a number of candidates.
• Defining contingency plans.
• Verifying and refining assumptions to see how the value of the business is impacted.
• Selecting the best business investment opportunity from a number of alternatives.

In this sense, you can use the discounted cash flow method as a powerful planning tool as well as a highly effective business valuation technique.

This is no idle question – with cyber attacks on the rise the safety and security of your business computer has never been more important.

If you are a professional advisor, the last thing you need is to experience a computer crash in the middle of a time-critical project or sustain a loss of sensitive client data.

As a business owner, you may be running a number of applications on your computer. If your system is compromised or taken over by online criminals, the loss to your business could be devastating.

So how do you make sure this does not happen to you?

Your business software safeguard – digital code signing

The good news is that the reputable business software vendors already take serious steps to protect you. One of the most important defenses in their arsenal is digital code signing of the software products.

How software code signing works

If you are installing a software application on a Windows computer, the Authenticode technology is your first line of defense. Before installation is allowed to go on, the Authenticode on your computer performs two critical checks:

• It verifies the identity of the software publisher. For example, in the case of ValuAdder, your computer informs you that the publisher is Haleo Corporation (that’s us!).
• It verifies the product itself. Continuing with the above example, you are notified that ValuAdder 5 is the software product you are about to install.

Only after the above checks have been successfully done are you advised to proceed with the software installation.

What happens behind the scenes during this critical step is really important:

First, Authenticode reads the encrypted signature included in your software product. Only the software publishers whose identity has been verified, domicile established, and corporate officers contacted can have the seal, known as the code signing certificate. This seal is required to produce the software signature for verification on your computer.

Since online crooks want to conceal their identity in order to avoid punishment, they will not have access to a code signing certificate such as one granted by VeriSign.

In addition, your computer checks that the software file is intact and has not been tampered with. You can then proceed with the product installation safely.

ValuAdder products – designed with your protection in mind

All ValuAdder business valuation software products are digitally signed by a VeriSign certificate. This authoritative third party endorsement is your assurance that your ValuAdder products will perform their functions while protecting your computer system.

Are you appraising an employment agency or an executive recruitment firm? Here are some vital industry statistics to consider:

Classified under SIC 7361, there are over 36,000 employment agencies of all types and sizes in the US alone. The industry as a whole generates a very impressive $29.9 billion in annual revenues and employs some 448,000.

Yet an average staffing firm is small: with annual gross revenues of around $1,000,000 and a staff of 13. The vast majority of recruitment companies are privately owned.

Business valuation methods for employment agencies

Successful staffing firms with consistent history of above average profitability and steady earnings growth are highly desirable acquisition targets. Recent sales of such companies give you an objective market evidence to estimate your company’s worth.

The usual tools are valuation multiples that relate the actual business selling prices to their financial performance. Typical valuation multiples used for market-based recruitment company valuations are:

• Business enterprise value to gross revenues or net sales.
• Enterprise value to net income, EBIT and EBITDA.
• Business value to total assets and owners equity.

Since the business valuation multiples are derived from similar employment agency sales, your business value estimates can be calculated as a range, from low to high, or a single value such as the median or average.

Example – valuation of an employment agency using multiples

To illustrate how comparable business sales can be used to value a staffing firm, let’s consider a typical business with these financial parameters:

• Annual gross sales: $1,000,000.
• Net income: $45,000.
• EBITDA: $62,350.
• Total business assets: $112,550.
• Owners equity: $55,200.

To estimate the firm’s fair market value, we pick a set of reasonable valuation multiples and calculate the results as follows:

Calculating the goodwill of a recruitment firm

Established professional business services firms, including employment agencies, can create considerable business goodwill. Often, the value of goodwill exceeds the appraised values of the business tangible assets. Consider using the classical Capitalized Excess Earnings method to calculate the value of business goodwill and total business value.

This serves to complement your market-based business valuation and provide additional insights into the value-creating factors in your company.

Income-based valuation of recruitment companies

For smaller owner-operator managed firms, the Multiple of Discretionary Earnings valuation method is an excellent choice. You can calculate your business value as a multple of its earnings and account for a number of key financial and operational performance factors.

For larger staffing businesses looking for outside financing or anticipating substantial changes in earnings going forward, the Discounted Cash Flow method is the preferred technique. Consider using a number of scenarios in your business valuation such as the best case, worst case and base case outcomes.

Each should be associated with a different earnings forecast and risk assessment. The business valuation results you get can be be averaged or used to establish a value range. Both formats are acceptable for formal business appraisal reporting.

If you are looking for a reliable source of valuation multiples to estimate your business fair market value consider the free resources readily available to you.

One of the most reliable sources of valuation multiples are regulatory filings made by public firms involved in mergers and acquisitions of private companies.

In the US all public companies are required to file statements disclosing material changes in the company’s ownership with the Securities and Exchange Commission (SEC). Shareholders of such firms have a legal right to know the key facts about such mergers and acquisitions, and especially how it affects the value of their stock holdings.

To meet this requirement, the filing public company needs to perform the valuation of the merged and acquired firm. This is then used as the basis to determine the per share cash value of the stock to be cancelled or an exchange ratio calculated to roll over the existing shareholders into the surviving firm’s stock.

To ensure that the business value is determined in a consistent and verifiable manner, public companies report their valuation results on the so-called enterprise value basis. This includes the market value of the acquired company’s equity plus debt capital, less cash and cash equivalent liquid assets.

Once you know the reported enterprise values and financials of similar private companies, you can easily calculate a number of key valuation multiples to use for your own firm’s value estimation:

• Enterprise value to business gross revenues or net sales.
• Enterprise value to EBITDA, net income or free cash flow.
• Enterprise value to business total assets.

Since all merger and acquisition filings are subject to the SEC scrutiny, you have the solid assurance of consistency and accuracy of the comparable business sales reporting. The result is a highly defensible and accurate basis to estimate your business value.

Note that the enterprise value-based valuation multiples are very useful to establish the value of similar private firms. This is because the underlying transactions resemble the typical private business acquisition scenarios:

• They involve transfers of controlling ownership interests.
• The discount for lack of marketability is accounted for if the acquired firms are private, as they often are.
• Financial statements are adjusted to bring them in compliance with the GAAP accounting standards.
• The business enterprise value is what private business buyers get in a transaction structured as a typical asset purchase.

Even in a challenging real estate market quite a few specialized construction companies continue to thrive. The secret of success? Here are a few points to ponder:

• Construction firms in a specialized, well-protected niche, tend to weather the storm better.
• Established companies with strong reputation in their market place stay busy even as competitors exit.
• Word of mouth referrals are even more critical to bringing new business when times are tough.

For example, while new construction volume may be down, construction defect restoration work is still needed. Specialist firms that excel at this often find that their services are in high demand. While no one business is truly recession proof, these types of construction companies are recession resistant.

Interestingly, these successful businesses are sought after acquisition targets – both by larger, well-funded competitors and financial buyers who look for a stable income stream. So even if valuations of many other companies in the market may trend lower, such specialist constuction firms hold their value well.

Business valuation methods for specialized construction businesses

Market activity is a very good indicator of a company’s fair market value. Selling prices of similar companies that changed ownership recently offer you a way to estimate what your own firm is worth. Consider using a number of valuation multiples that help you calculate your  business value based on its financial performance, such as revenues, profits, cash flow or business asset base.

Example – valuing a construction defect restoration company using valuation multiples

To demonstrate the method, let’s take a typical construction firm with the following recent financial performance:

• Annual gross revenue: $2,000,000.
• Net sales (less returns and discounts): $1,950,000.
• Gross profit: $950,000.
• Net income: $210,000.
• EBIT: $225,000.
• EBITDA: $230,000.
• Seller’s discretionary cash flow (SDCF): $350,000.
• Furniture, fixtures and equipment (FF&E) assets: $195,000.
• Inventory: $100,000.
• Total business assets: $465,000.
• Owners’ equity: $155,000.

We pick a set of reasonable valuation multiples and calculate the fair market value of this company as follows:

Note that, by convention, the business value above includes all business tangible assets and goodwill. It does not include the cash, accounts receivable, and the business owned real property, if any.

Additional business valuation methods to cross-check your results

To demonstrate the unique value-creating attributes of your construction company, consider using income-based valuation methods. For smaller, owner-operator managed businesses, the Multiple of Discretionary Earnings is a good choice. For larger firms, the Discounted Cash Flow method is typical.

If the company has established itself as a leader in its market, the value of business goodwill can be a large part of total business value. You can measure business goodwill by using the well-known Capitalized Excess Earnings method, also known as the Treasury Method.

If you need to get an objective estimate of business value, consider using the valuation multiples derived from the recent sales of similar businesses. There are a number of advantages:

1. Business valuation with multiples is easy to understand and explain.
2. In times of economic uncertainty, business people and professional appraisers carefully consider the market trends when valuing a business. Market value estimates using the valuation multiples are an excellent way to do so.
3. If the business is to be bought or sold, market comparisons are a must to defend your asking or offer price.
4. Market comps are also a great way to prove your point if your business valuation is challenged.

Types of valuation multiples

Business appraisal experts and seasoned investors use quite a number of valuation multiples depending on the specific business or the reasons for business valuation. Here are the most common choices:

• Valuation multiples based on business gross revenue or net sales.
• Gross and net profit-based valuation multiples.
• Earnings based multiplies relating the business value to its EBIT, EBITDA, or discretionary cash flow.
• Valuation multiples based on business assets and owners’ equity.

Reasons for choosing the earnings-based valuation multiples

Business valuation is about earnings and risk. For small owner-operator managed companies, the discretionary cash flow based multiples are the usual choice. For larger small and mid-market businesses the typical basis is EBITDA. There are a couple of reasons why the EBITDA based valuation multiple is often preferred:

• Business owners have control over the company’s capital structure. Hence, the interest expense is viewed as discretionary and added back to calculate the available cash flow.
• Many private firms are structured as pass-through entities for tax purposes, such as S-Corporations or LLC companies in the US. Since these companies do not pay tax directly, adding back the taxes makes sense.
• Depreciation and amortization are paper expenses and do not affect the business cash flow. They are added back to calculate EBITDA.

To sum up, EBITDA is a good way to represent the available business cash flow to calculate the value of private companies. The EBITDA-based valuation multiples are a common choice in valuing larger businesses in these industries:

• Manufacturing firms
• Technology companies
• Professional services businesses

Current EBITDA valuation multiples for major industries – some examples

As the market conditions change, so does the value of your business. Valuation multiples based on recent business sales help you track changes in your company’s market value. Here are some typical EBITDA valuation multiples by industry:

The EBITDA multiple for software companies may seem high. However, these firms tend to show considerable variation in earnings. It is a good idea to check your results using other valuation multiples. For example, these firms tend to price at about 2.5 times the net sales.

If you turn to a commercial lender for a business loan, expect the focus to be on the company’s cash flow. In other words, the lender wants to know whether the business will be able to repay the loan from its profits and cash flow.

Lender’s view of value: ability to repay plus valuable collateral

Just in case this assumption does not work out, the lender will want the business owners to put up sufficient collateral – typically in the form of valuable business assets. Should the loan repayment become a problem, the lender will lay a claim on these assets.

Loan to value depends on how quickly the assets can be converted into cash

For a lender it is important to establish the marketability and values of the business assets pledged against the loan. The more easily the asset can be converted into cash, the higher the loan to value figure.

You can expect the bank to offer around 80% of the value of current accounts receivable. On the other hand, most lenders will likely offer just around 50% of the value of business furniture, fixtures and equipment (FF&E) assets.

Inventory is another business asset that the lenders scrutinize carefully. For a manufacturing company, the bank is likely to lend against the values of raw materials and finished goods inventory. In the event of default, the finished goods can be sold off to a jobber, while the raw materials usually can be returned to the supplier or sold at a discount to a competitor.

Since the bank is not in a position to complete the production, the work-in-progress inventory is usually not a good collateral.

Experienced lenders are well aware that some inventory may be slow moving. In the event of default, this type of inventory is much harder to convert into cash quickly.

Good inventory control records are very important if you are to get high loan to value figures for inventory. Writing off obsolete inventory has the additional advantages of reducing your property taxes and insurance costs.

Conservative commercial lenders are also likely to apply a haircut to inventory levels in excess of the industry average. The assumption here is that the business inventory value is likely overstated or partially unmarketable.

Business valuation results depend on the premise of value!

A major cause of disagreements between business owners and lenders is how the value of pledged business assets is determined. Business appraisal can be done under several premises of value. Depending on the choice of premise, the business valuation results and, therefore, the amount of business loan, can vary dramatically.

Lender’s position: liquidation premise of business value

Expect the lender to take a conservative position and use the so-called liquidation premise of business value. This establishes the worst case scenario in the event the business fails to repay the loan and the collateral needs to be liquidated quickly.

Business owners’ view: going concern

For the owners of a going concern business, the typical premise is value in use. The resulting business valuation is considerably higher than under the liquidation assumption.

Both the business owners and the lender are right. However, each party is viewing the business value from a very different perspective!

Despite the current economic headwinds, many building maintenance service companies with established client contracts continue to thrive. There are some 92,300 such firms in the US alone, classified under the SIC code 7349.

The industry segment contributes an impressive $28B in annual revenues to the economy employing just under 840,000 people. The typical janitorial services company is quite small – generating around $300,000 in gross annual sales with a staff of 9.

Business valuation methods for janitorial service companies

Given the size of the market and the recurring need to clean and maintain office buildings, the janitorial companies tend to be “recession-resistant”.

Companies with stable earnings from long-term commercial contracts are bought and sold regularly. This is very good news: business selling prices and terms from such deals offer you an excellent way to estimate the value of your janitorial service company.

The typical tools are valuation multiples that relate the actual selling prices of similar companies to their financial performance. You can apply these valuation multiples to estimate the value of your company based on its revenues, profits, EBITDA, cash flow, asset base and owners equity.

Example: valuing a building maintenance business using valuation multiples

To demonstrate this market approach to valuing a business, let’s pick a typical private janitorial service company with the following current financials:

• Gross revenue: $300,000.
• Net sales: $290,000.
• Net income: $60,000.
• EBITDA: $75,000.
• Seller’s discretionary cash flow (SDCF): $110,500.
• Furniture, fixtures and equipment (FF&E) assets: 55,000.
• Inventory: $10,000.
• Book value of owners’ equity: $35,000.

To calculate the fair market value of this business, we choose a set of sensible valuation multiples as follows:

Note that this averages to about 0.86 times the business gross revenues.

Other business valuation methods for janitorial service companies

To supplement the market-based valuation and check your results, consider using the Multiple of Discretionary Earnings method. This well-known technique lets you assess business value from a totally different point of view: based on the company’s earning power and 14 key financial and operational performance factors.

Companies with a long history of success in their market may have built up significant business goodwill. As a result, they may be worth well above the value of the business tangible assets. The Treasury Method is a great choice to calculate the value of business goodwill and total value for such firms.