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.

Continuing our discussion about valuation of software services companies, let’s focus on the market valuation approach.

A central technique under this approach is the comparative transaction method. It is especially useful for valuing private software firms. In a nutshell, the method lets you determine the value of your software firm in comparison to similar companies that have recently sold.

Privately owned software companies with a solid track record of profitability are frequent acquisition targets. You can study the selling prices of successfully closed deals in relation to the financial performance of such companies.

Valuation multiples

Valuation multiples are the usual tools to estimate the fair market value of your software company using the market approach. For example, you can calculate your company value in relation to its revenues, gross profit, net income, EBIT, EBITDA, discretionary cash flow or business assets.

One of the main advantages of using such valuation multiples is that they are based on actual sales thus offering a highly objective and defensible way to estimate what your software company is worth. This is especially useful if you need to prove your business value to a skeptical investor, or defend your valuation in court or before the tax authorities.

Example - valuing a custom software development company using valuation multiples

We will take a typical contract software development firm with the following financials:

• Gross revenue: $1,300,000.
• Net sales: $1,200,000.
• Gross profit: $1,000,000.
• Net income: $230,000.
• EBIT: $370,000.
• EBITDA: $385,000.
• Seller’s discretionary cash flow (SDCF): $400,000.
• Furniture, fixtures and equipment (FF&E) assets: $450,000.
• Total business assets: $500,000.
• Book value of owners’ equity: $225,500.

We pick a set of reasonable valuation multiples and estimate the value of this software company as follows:

Each business value estimate can shed a different light on what drives the value of your software company. For example, a high business valuation result based on EBITDA may point out that the company manages its profitability better than the industry average.

An asset rich firm will likely show a higher business value estimate based on the value of its total assets, both tangible and intangible, such as internally developed technology or business processes.

Using business valuation as a strategic tool

Showing how business value depends on your company performance in this way can help you in strategic planning and decision making.

A key question: what value factors can be improved to increase the overall business value? You can focus on the areas that can enhance the value of your company, then measure the result by repeating your business appraisal.

When it comes to valuing a business, size matters. The main reasons for this is that companies of different sizes face very different risks. Most investors believe that large companies are less risky than their small counterparts. Other things being equal, the smaller firms need to generate higher returns to compensate their investors for the extra risk they take.

How much more risk? The largest Fortune 500 firms with market capitalizations approaching $500M are about as risky as the overall market. On the other hand, for businesses that are valued well below $150M, the investors currently demand the additional risk premium of around 9.5%. That’s the bracket where most small businesses fit in.

Here are some reasons for this risk perception difference:

• Large companies have better access to debt and equity capital.
• Larger firms tend to be more diversified in their product and service offering.
• Small companies usually have a relatively limited market reach.
• Large firms with deep pockets are often preferred by customers who look for a stable, long-term vendor.
• Large companies have an easier time attracting top management and skilled talent.

How company size affects its value

To illustrate, we will use the well-known Build-Up model to calculate the capitalization rate for a fictitious Fortune 500 company and a small business. We will assume that both firms are debt-free and their earnings grow at 5% per year. Both companies are in the general merchandize retail industry, SIC 5399.

In this example we have included the company specific risk premium of 4% for both firms.

The valuation multiples above tell a remarkable story: the large company commands the valuation ratio that is almost twice as high as its small business counterpart!

In other words, it takes almost $2 of business earnings for the small company to contribute as much to its value as $1 for the Fortune 500 firm.

Do you own a lanscaping services company? Need to determine the value of your own business or prepare an appraisal for a client? Here are some interesting industry statistics to consider: 

Key landscaping industry statistics

Classified under SIC code 0781, there are over 49,370 landscaping planning, design and counselling establishments in the US alone. The industry as a whole generates $10.9B in annual revenues and employs over 205,000 people. Yet an average landscaping company is a typical small business: it produces around $200,000 in annual sales with a staff of 4.

Business valuation of landscaping companies

By far the most objective evidence of what a landscaping company is worth is recent sales of similar businesses. Business appraisers refer to this business valuation technique as the Comparative Transaction Method.

Valuation multiples derived from such business sales offer you an excellent tool to estimate your business value. Here are the typical multiples used for landscaping business appraisals:

• Multiple of gross revenues or net sales.
• Multiple of gross profit.
• Multiple of net income.
• EBIT and EBITDA based valuation multiples.
• Multiples relating your business value to its fixed or total assets.
• Business value as a multiple of owners’ equity.

Example: valuing a landscaping company using multiples

Let’s take a typical landscaping services firm with the following financial parameters:

• Annual net sales: $600,000.
• Gross profit: $410,500.
• Net income: $56,250.
• EBIT: $57,000.
• EBITDA: $59,600.
• Total business assets: $195,000.
• Book value of owners’ equity: $102,500.

We next pick a set of reasonable valuation multiples to calculate the company value as follows:

Asset and income methods for valuing a landscaping business

To complement your market-based valuation,  consider the the well-known Multiple of Discretionary Earnings method. This income-based business valuation technique is especially suitable for valuing owner-operator managed landscaping service companies.

For a business that has excellent reputation in its marketplace, the value of business goodwill can be considerable. To appraise the value of business goodwill, consider using the Capitalized Excess Earnings method, known as the Treasury Method. Many professional business appraisals use this asset-based method to value goodwill as well as determine the total business value.

If you own a software firm, plan to start one or acquire an existing company, here are some interesting facts to consider:

The two main segments of the software industry are custom software services and pre-packaged products.

Software development services firms

Classified under the SIC code 7371, the firms in the software service industry concentrate on creating solutions for clients, usually other businesses.

The industry segment as a whole counts over 49,500 establishments in the US alone. These software companies employ around 572,000 people and generate over $57.7B in annual sales. The average contract software development company makes about $1.3M in annual revenues and employs a staff of 12.

Software product development companies

Software companies that develop and sell their own products are classified under the SIC code 7372. The pre-packaged software industry has just under 19,000 firms operating in the US market with a total employment force of some 264,000.

The segment generates an impressive $152B in annual sales. An average company does about $9.2M in revenues per year with a staff of 14.

One interesting observation you can make is that the software services industry creates fewer dollars with more people. One reason is that the software services are more labor intensive. However, the service companies have an easier time establishing a loyal customer base and recurring business.

Key value drivers for software companies

Regardless of which market segment your software company is in, these key factors make the major difference to its value:

Earnings growth prospects

Software products can be highly profitable if focused on the right market segment with significant demand. Product firms especially can experience significant revenue growth quickly with the right product mix.

Profitability

Keeping costs under control is not an easy task for a software company. The costs of developing and marketing software products are very high. The firms that manage growth while keeping their cost from escalating are far more valuable than their unprofitable counterparts.

Stability of earnings

Maintaining consistent level of sales and profitability can be very difficult especially for pure product software companies. Competition can introduce an alternative product and sudden market changes can make a star product obsolete very quickly.

This is where the service companies tend to do better - the customer loyalty tends to translate into repeat business, stable prices and steady earnings. The costs of entering the new market segments are also lower for software services companies as they tend to rely on  existing customers and referrals to do so.

Business valuation methods for software companies

As with any business, you can value a software company three ways, known as appraisal approaches:

• Asset - based on the company’s asset base.
• Income - based on the firm’s earning power and risk.

Established software firms tend to be frequent acquisition targets. Hence, there is solid evidence of their market value as shown by the actual business selling prices. Thus, you can use the market valuation methods quite effectively to appraise your software business.

At the same time, the growth potential is a key element of value in any software company. Income-based business valuation methods, such as the Discounted Cash Flow technique, are an excellent choice to value a software firm.

Combined Market and Income approach: First Chicago Method

For a highly accurate business appraisal, you can combine the two approaches. This technique is often referred to as the First Chicago method. Under this method, you can assess the value of your software business using the Discounted Cash Flow method. This requires that you create a set of earnings forecasts and assess the business risk. 

Since the future is never certain, you can improve the accuracy and validity of your business appraisal by repeating the Discounted Cash Flow analysis under a couple of possible scenarios, such as the worst case and best case outcomes. You can average the results to come up with an estimate of what your company is worth.

The market comparisons serve as the objective proof to back your income-based valuation results. Since the market valuation is based on the actual data on similar business sales, it tends to act as a sanity check on your forward-looking income-based valuation.

Again, combine the income and market-based valuation results for a highly defensible, comprehensive estimate of what your software company is worth.

If you talk with professional business investors or business brokers, soon enough you will hear them mention business valuation ratios. Business appraisers refer to these tools as valuation multiples.

Basically, the ratios are a technique to estimate the value of a business based on comparable business sales. Such market-based valuation tools are very useful in a number of situations that call for a defensible, objective business appraisal:

• Business sale or purchase. Buyer and seller can justify their valuations based on the objective, empirical evidence.
• Legal disputes which often require that the fair market value of a business be determined. Again, objective market proof of business value is a great way to resolve disagreements.
• Tax issues such as gift, estate and income taxes. Tax authorities are very keen on checking the market data to verify the business appraisal results submitted by tax payers.

Typical ratios used in business valuation

Since no two businesses are the same, the actual business selling prices will differ from one transaction to another. Relating the selling prices to the business financial performance measures is the best way to develop reliable ratios for your business valuation.

As you can expect, the business income statement and balance sheet items are the usual choice of basis to calculate the business valuation ratios. Here are the most common ones:

1. Business selling price to gross revenues or net sales
2. Price to gross profit
3. Price to net income
4. Price to EBT, EBIT and EBITDA
5. Price to seller’s discretionary cash flow or net cash flow
6. Price to fixed business assets or total asset base
7. Price to owners’ equity.

The accuracy of each business valuation ratio varies by industry, company size, and the time frame when the business sale comps have been selected. The best ratios are those showing the smallest spread of values, from low to high. This indicates that business people rely on some business valuation ratios more when pricing the actual business acquisitions.

Choosing the ratios for your business appraisal: best practice

One way to develop a highly defensible market-based assessment of your business value is to use several ratios or valuation multiples at once. Each will produce a result indicating what your company may be worth based on the specific financial performance measure.

You can then use these valuation results to come up with a solid estimate of business value. Let’s say that the lowest business value for your company as determined by the price to gross revenue valuation ratio is $1,000,000; the intermediate value based on the discretionary cash flow is $1,100,000; while the highest is $1,250,000 as indicated by the price to net income ratio.

You can conclude that the market value of the business will fall somewhere in the range established by these numbers, in this case $1,000,000 - $1,250,000.

On the other hand, the numbers can be averaged to give a single number for the business value: $1,116,667.

In fact, both the range and a single value number reporting is industry-standard for professional business appraisals.

Privately owned and operated florists are a major part of the retail industry. Classified under the SIC code 5992, there are around 35,650 such establishments in the US alone. The industry as a whole generates an impressive $6.6B in annual revenues and employs over 135,000 people.

Yet an average flower shop is a classical small business: producing around $200,000 in annual sales with a staff of 4.The industry is highly fragmented with the top 5 companies accounting for less than 2.5% of the total industry revenues.

Key value drivers for retail florists

The product for flower shops is arranged cut flowers that usually account for over 50% of a store’s revenues.  Florists with significant commercial accounts that tend to result in stable recurring revenues are valued above the average.

Another key value driver is an attractive store location with the rent expenses below 6% of the shop’s gross revenue. The highest valued flower shops are located away from the major “big box” competitors such as do-it-yourself home improvement or grocery chain stores.

The florists that focus on the special event and gift market segments tend to command higher business valuations. Essentially, such flower shops differentiate on superior service that leads to customer loyalty, higher profitability and, not surprisingly higher business value.

Sales from an online presence or phone orders tend to be more cost-effective ways to generate sales. Some of the most valuable flower shops achieve close to 80% of their revenues through these channels.

Business valuation methods for flower shops

Florists with a track record of highly stable, above average earnings are very desirable and sell often. If you study such business sale comparables, you can develop a very good idea of what your business is worth.

The typical tools to estimate your business value is to use the valuation multiples derived from such business sales. The multiples relate the actual flower shop selling prices to their financial performance.

Thus, you can calculate your business value in relation to its revenues, profits, EBIT, EBITDA, cash flow, assets or owners equity.

Here are the typical valuation multiples used to estimate the value of a flower shop:

• Business value based on gross revenue or net sales.
• Business value based on net income.
• Business value based on EBIT and EBITDA earnings.
• Business value based on the seller’s discretionary cash flow.
• Business value based on the furniture, fixtures and equipment assets.

Flower Shop Valuation using Business Sale Comps

Example: valuing a flower shop using valuation multiples

To demonstrate the idea, let’s pick a typical retail florist business with the following financials:

• Business gross revenue: $250,000.
• Business net sales: $225,000.
• Net income: $35,553.
• EBIT: $36,000.
• EBITDA: $39,500.
• Seller’s discretionary cash flow: $154,247.
• Furniture, fixtures and equipment assets: $25,307.
• Inventory: $4,601.

We pick a set of reasonable valuation multiples to calculate the value of the business as follows:

Other methods to use for valuing a florist business

You can value an established owner-operator run flower shop by the well-known Multiple of Discretionary Earnings method. This income-based business valuation technique lets you determine the value of the business based on its earnings outlook and a set of key financial and operational performance factors.

Since many privately owned florists are lifestyle businesses, the Multiple of Discretionary Earnings is particularly well suited for their business valuation.

For a florist that has created an solid reputation in its market, the value of business goodwill can be considerable. To appraise such a business, consider using the Capitalized Excess Earnings method, known as the Treasury Method. This technique is specifically intended to help you determine the value of business goodwill and total business value.

If you want to get a top quality business appraisal, consider using several well-known business valuation methods.

Such a multi-method business valuation is standard in professionally prepared appraisals. Since each method represents a different view of how business value is measured, reviewing the results from several different methods gives you a comprehensive picture of what the business is worth.

In practice, you can choose some valuation methods over others because they are more suitable for your specific situation. Here are the typical method choices used for valuing established service firms:

• Valuation multiples based on comparable business sales
• Multiple of Discretionary Earnings valuation method
• Discounted Cash Flow method
• Capitalized Excess Earnings method

Using market comps to value a service business

Successfull companies in the services industry sell often. Hence you can do valid market comparisons to recent business sales to see what your business is worth.

The valuation multiples are ratios that help you estimate the market value of a business based on the actual selling prices of similar firms and your company’s financial performance measures. Business value is usually measured against the firm’s revenue, profits, cash flow, EBIT, EBITDA, business assets or owners equity.

Valuing a company by direct capitalization of earnings

Smaller service businesses, especially those with mostly recurring revenues, can be valued using the Multiple of Discretionary Earnings method.

Discounting cash flows to determine business value

For larger firms or those experiencing significant earnings fluctuations over time, the Discounted Cash Flow method may be more appropriate.

Valuation of business assets: tangibles and goodwill

Business goodwill can be a big part of the total asset base for service companies. To determine the value of goodwill, consider using the Capitalized Excess Earnings method, also called the Treasury Method.

Establishing business value

The results you get by using the various business valuation methods may differ. This is quite normal since each method uses a different set of rules to determine business value.

You can use your results to establish a range of business values, from low to high. On the other hand, you can average your business value results and come up with a single number. Both techniques are very common in professional business appraisals.

If you are considering an outside investment for your business or looking to put money into a promising company, business valuation is surely to be one of the key data points in your decision making.

Significant investments are usually made in order to achieve some strategic goals such as increasing the business revenues, entering a new market or developing the next generation products.

Business valuation - a forward-looking exercise

The value of the business is thus driven by its future earnings. It also depends on the level of risk the company is likely to face as it pursues its plans.

Perhaps the most widely used business valuation methods for investment purposes are the income-based discounting techniques. The best known of these is the Discounted Cash Flow method. It enables you to determine the business value today, known as the present value, based on three fundamental inputs:

1. Future earnings forecast over some period of time, e.g. 5 years.
2. Discount rate which captures the business risk.
3. Long-term or terminal business value - or what the business will be worth at the end of the forecast period.

Savvy investors usually are very good at assessing the company’s prospects and risk. Since they consider a number of investment projects, they have an idea about the kind of return on investment they expect.

Put another way, they see the discount rate as the rate of return they require to become interested in a business investment.

Comparison of business value and investment - Net Present Value

One common technique these investors use is the Net Present Value calculation. It combines the Discounted Cash Flow business valuation with a direct comparison to the value of the proposed investment.

If the difference between the business value and the amount of investment is positive, the investment makes financial sense.

A special case is when the business value is equal to the investment value. The discount rate that makes this happen is known as the internal rate of return, or IRR for short. At this rate of return the business creates precisely the amount of value that justifies the investment.

Internal rate of return as a decision making tool

You can use the internal rate of return as a screening tool for a proposed investment.

If you are a business owner considering an outside investment, you should know both the amount of investment and the rate of return the investor expects. You can use the Net Present Value calculation to see if your business can grow in value to make the cut.

If you are thinking of investing in a company and have the size of investment in mind, then you can use the Net Present Value calculation to see if the business can create enough value to meet your required rate of return on investment. 

Using Net Present Value in a number of what-if valuation scenarios

Time value of money can make a major difference here. You can run a number of scenarios with different cash-out assumptions. Is an early exit a better strategy than waiting longer as the business value grows? The Net Present Value calculation helps you make such important decisions in a precise, fact-based manner.

ValuAdder gives you a set of standard tools to determine the value of a business, structure an acquisition deal, and make sound investment decisions.

Business Valuation System

One of the most challenging tasks you are likely to face when considering an outside investment is how to determine the value of your company.

Referred to by venture capitalists as the post-money valuation, this key step gives you a number of strategic decision data points:

• What the entire company is worth, known as the enterprise value.
• How the business ownership interests are split between the founding team and external investors.
• Whether the founders retain the controlling ownership of the company after the investment has been made.
• Is the investment worth taking given its effect on business value?

Business valuation of a high growth firm - First Chicago Method

Since the infusion of outside capital is likely to change the business earnings prospects going forward, the Discounted Cash Flow method is the standard choice for investment-driven business valuation.

This income-based valuation method lets you focus on the company’s earnings prospects and risk directly. The result is the “present value” of the firm - what it is worth today.

The additional capital can make a major difference to the business’s earnings prospects. Since the future is uncertain, it is best to create a number of forecasts and run your Discounted Cash Flow valuation for each:

1. Best case - under the most favorable assumptions of business performance.
2. Base or most likely case.
3. Worst case - if the business encounters unexpected “head winds” in the near term.

You can view the results as a range of possible business values or average them to come up with a single valuation number.

Business Valuation based on Cash Flow and Risk

Note that this valuation analysis is inherently forward looking and involves a number of subjective assumptions on your part. It is a very good idea to check the market in order to confirm your valuation results. Recent sales of comparable businesses give you an objective evidence of selling prices.

If you relate the business selling prices to the the firms’ financial performance, you can see how the market values these companies. More importantly, using the valuation multiples derived from the market comps you can estimate the market value of your own business.

Valuing a Business based on Market Comps

This combination of the comparative market value analysis and Discounted Cash Flow valuation is known as the First Chicago Method.

The method’s power is in combining the theoretically precise yet subjective business valuation based on its income prospects with a highly objective “reality check” of business market value based on the actual business sales.

You can easily implement the First Chicago method using the ValuAdder business valuation software:

• Select the Market Comps tool for your market-based valuation.
• Create a number of Discounted Cash Flow valuation tools, one for each valuation scenario.
• Calculate your business valuation results.

If you own a land surveying firm or plan to acquire one, here are some interesting industry statistics. Classified under the SIC code 8713, there are some 12,900 such establishments in the US alone, employing over 78,000.

While the industry as a whole generates $4.6B in annual revenues, the average land surveying company is small business, employing a staff of 6 and making around $400,000 in annual gross revenues. In fact, 97% of surveying practices employ fewer than 24 staff!

Business valuation of surveying firms: Market Comps

Established, profitable land surveying practices are highly desirable acquisition targets. Hence, there is considerable market evidence of selling prices for such firms. You can use these Market Comps in order to develop a good idea of what your surveying company is worth.

Valuation multiples calculated from such comparable surverying firm sales lets you related your business financial performance to its potential selling price and, therefore, the company’s fair market value. Here is a list of valuation multiples that are typical in the industry:

• Price to gross revenues
• Price to net sales (less returns and discounts)
• Price to gross profit
• Price to net income
• Price to EBIT
• Price to EBITDA
• Price to seller’s discretionary cash flow (SDCF)
• Price to furniture, fixtures and equipment (FF&E) assets
• Price to total assets
• Price to book value of owners’ equity

You can develop a very comprehensive idea of what your surveying practice is worth by using this set of valuation multiples. For an example, see the sample ValuAdder Business Market Value Report.

Example: using valuation multiples to appraise a surveying firm

To show how the Market Comps and valuation multiples can be used to value a surveying company, let’s pick a hypothetical firm with these financial parameters:

• Annual gross revenue: $500,000
• Net sales: $480,000
• Gross profit: $430,000
• Net income: $40,000
• EBIT: $45,000
• EBITDA: $47,000
• SDCF: $275,000
• FF&E assets: $175,000
• Owners’ equity: $50,000

We apply a set of reasonable valuation multiples and calculate the business value across all 9 financial performance factors. Here are the results:

Notice that the business value estimates based on the discretionary cash flow and assets are higher than the average. That’s because our example firm excels in its ability to generate positive cash flow and has a relatively high asset base.

Are you using a modern 64 bit computer system? Or do you work on both 32 and 64 bit machines?

Now you can use ValuAdder business valuation software on both types of computers - and get identical performance and accurate business appraisal results.

What makes this magic possible? ValuAdder leverages the Java 6 computing platform to give you the business valuation system that automatically detects your computer’s capabilities to give you top performance.

Tools to determine business value - and maximize your return on investment

You can save time and money by using the same ValuAdder program on your Windows XP as well as the state-of-the-art Windows 7 and Vista 64 bit systems.

Business valuation software that gives you peak performance

On a MAC computer, you can take full advantage of the MAC OS X.6 Snow Leopard system performance, or run ValuAdder on a MAC OS X.5 Leopard or X.4 Tiger systems.

All this makes your ValuAdder business valuation tools a highly economical investment - you can run the same tools on any computer system and exchange your appraisal results across your entire network - or with clients who work on completely different computers - Windows, Mac OS, Linux or Unix!

For example, you can prepare a business appraisal for a client, then package the entire project using a ValuAdder Scenario, and email it to your client for review. While you may be doing your work on a Windows computer, your client can open and edit the scenario on an Apple MAC.

To make this possible, ValuAdder uses the standard XML format for data exchange.

If you own an established industrial equipment rental and leasing business, plan to buy one or need to provide a business appraisal for a client, consider adding the market-based valuation methods to your toolkit.

Classified under the SIC code 7377, profitable firms operating in a well defined, protected niche, are quite valuable and sell often. This means that there are plenty of business sale comparables you can use to estimate what your company is worth. Indeed, comparison to recent sales of similar businesses offers your the most convincing way to determine and prove the value of your own business.

Business valuation by the Comparative Transactions Method

This market-based technique is formally called the Comparative Transaction Valuation Method. The typical tools are a range of valuation multiples derived from past business sales.

These multiples relate the actual business selling prices to some measure of financial performance, including the equipment rental business gross revenues, net sales, gross profit, net income, EBIT and EBITDA, discretionary cash flow, assets and owners equity.

Once you know the valuation multiples for your business, you can calculate the fair market value of your firm by applying the multiples to your company’s financial performance parameters.

For example, if the median price to gross revenues multiple is 0.4 and your company’s current gross revenues are $4,000,000; then the estimated business value is $1,600,000. You can apply other multiples to refine and cross-check your estimate.

Example: market-based valuation of an equipment rental business

Let’s take a typical privately owned equipment rental and leasing firm with the following financials:

• Gross revenues: $4,000,000.
• Net sales: $3,750,000.
• Gross profit: $1,200,000.
• Net income: $50,000.
• EBIT: $80,000.
• Seller’s discretionary cash flow (SDCF): $270,000.
• Inventory: $620,000.
• Total assets: $1,500,000.
• Owners’ equity: $700,000.

For this example, we pick a set of reasonable valuation multiples as follows:

• 0.4 times the business gross revenues.
• 0.45 times the net sales.
• 1.25 times the gross profit.
• 25 times the net income.
• 17 times the EBIT earnings.
• 1.7 times the SDCF (SDE).
• 1.3 times the business total assets.
• 3.5 times the owners’ equity.

Applying these multiples to the company’s financials above, we get the following business valuation results:

A single number or a range of business values

Note that calculating the average is just one way to assess what your business is worth. You can also use the set of business valuation results to establish a range of values, from low to high. In this example, your company’s market value is likely to be between $1,079,000 and $2,450,00.

Using Market Comps for Business Valuation

Our customers often ask us this question:

ValuAdder offers a number of business valuation methods. Does using multiple valuation techniques reduce business risk?

Our answer is this: applying a number of methods to value a business helps you reveal and assess the business risk much better than using just one method.

Appraising a business based on its cash flow

Let’s say that you are valuing a company and decide to use the Discounted Cash Flow method. This method relies on the discount rate for business risk assessment. The classical Build-Up model to calculate the discount rate works as follows:

1. Start with the risk-free rate of return. The yield on long-term US Treasuries is a common choice.
2. Add the equity risk premium - the additional return you get investing in the stock market.
3. Add the premium for company size - since smaller firms tend to be riskier than Fortune 500’s.
4. Add the industry-specific risk premium.
5. Assess the company-specific risk and add the corresponding premium.

Usually, the company-specific risk assessment is the hardest part, and the greatest cause of mistakes. Needless to say, improperly calculated discount rate will give you erroneous business valuation results.

A different perspective - market based business valuation 

To verify the results your get with the Discounted Cash Flow method, you may consider using the market-based valuation techniques. Here, you study the recent sales of comparable companies. You can see how other business people assess risk by calculating the valuation multiples they applied when valuing the businesses they bought or sold.

Review of statistically derived valuation multiples gives you an idea of the levels of risk for companies similar to yours. While each business is unique, sharp deviations from the industry norm call for an explanation and may point out an error in your analysis.

Asset based business appraisal - another view of business value 

You can also add asset-based valuation methods to shed further light on business risk. For example, using the Capitalized Excess Earnings Method shows just how well the business generates returns for its owners, given the capital invested.

Notice that the various methods adopt a very different view of business value. Yet all these different perspectives complement each other to expose the same fundamental drivers of business value - risk and return. 

Business Valuation using Multiple Methods

If you need a recipe for an accurate, defensible business valuation make sure you choose a number of professionally accepted business valuation methods to do it.

Valuing a business requires that you carefully analyze the company across a number of economic fundamentals. Professional business appraisers approach business valuation in three ways:

1. Asset approach
2. Income approach
3. Market approach

Selecting and applying a number of proven valuation methods under each approach gives you a comprehensive view of the business value.

Using the asset-based methods such as the Asset Accumulation or Capitalized Excess Earnings, you can determine the company’s value based on the values of its assets.

The income valuation methods let you estimate the value of the company based on its earning capacity and risk. On the other hand, the market based appraisal methods focus on comparison of your business to similar firms that have sold recently.

All these methods take a different view of what drives business value. No one method is better than the other. That is why selecting a number of valuation methods is the best way to create a sound business valuation.

Given all the method choices, which ones should you pick? This depends on your specific business situation. Here are some suggestions:

Start-up valuation

Valuing a young company presents unique challenges. Since most comparable business sales involve established firms, it makes little sense to use the market-based valuation methods.

Asset based valuation methods focus on establishing the value of the business based on a proven, optimized asset base. Often, business goodwill is a large part of business value, especially for businesses in the service industry. Yet it takes time to build goodwill in a business.

A start-up’s value depends on its potential to generate future earnings at an acceptable risk. This leaves you with the income-based valuation method choices. One of the best ones is the Discounted Cash Flow method. You can calculate your business value based on a number of earnings forecasts, each with its own risk profile represented by the appropriate discount rate.

Business valuation of an established cash cow company

Established firms that tend to generate reliable, steady income streams are very desirable. As a result, they are frequent acquisition targets. This gives you plenty of business sale comparables data to make an accurate business market value assessment.

Direct capitalization methods, such as the Multiple of Discretionary Earnings method, are an excellent choice for valuing companies with stable, recurring earnings.

Steady earnings tend to be associated with a large, loyal customer base. The business becomes an institution in its market place which creates considerable goodwill. You can use the famous Treasury Method to calculate the value of business goodwill and total company value.

Valuing an owner-operator managed small business

If your business operates in the service, retail or wholesale industries, comparable business sales abound for small, successfull companies. Market based business valuation methods work very well in valuing such firms.

The Multiple of Discretionary Earnings method is a very common choice under the income approach. In addition to the business earnings, the method lets you determine the business value based on a number of financial, operational and lifestyle factors.

Professional practice valuation

Professional practices are a special type of service firms. Perhaps the biggest difference is that they tend to create considerable business goodwill. If you need to appraise a medical or dental practice or an accounting firm, the Capitalized Excess Earnings method should be high on your list.

For larger practices the Discounted Cash Flow method is the typical choice. On the other hand, you can value a single practitioner firm using the Multiple of Discretionary Earnings method.

Whether you are valuing an established company or a start-up, the income-based business valuation methods are a wise choice. For businesses that tend to generate a steady stream of earnings, the direct capitalization methods such as Multiple of Discretionary Earnings or Capitalization of Earnings work very well.

Using these valuation techniques you can assess the value of a business based on its ability to generate earnings at an acceptable level of risk. Direct capitalization valuation methods use the capitalization rate to capture the business risk.

Needless to say, the accuracy of your business valuation depends largely on your choice of the capitalization rate. One common problem you may have to handle is negative cap rate values.

How the capitalization rate is calculated

How can a cap rate be negative? Consider the formula used for its calculation:

C = D - G

Here C stands for the capitalization rate, D is the discount rate and G is the expected long-term growth rate in the income you are capitalizing.

If your estimate of the growth rate G exceeds your discount rate D, the calculated cap rate becomes negative.

Business risks imply a positive cap rate

While the math can produce a negative result, the economically sensible cap rates are always positive. Put differently, your business always faces certain risks.

The typical reasons for a negative cap rate calculation are:

• Underestimation of business risks that leads to a low discount rate calculation.
• Overestimation of the earnings growth the business is likely to see over the long term.

The root cause of incorrect cap rates - rosy assumptions about future business earnings and risk

When you get a negative cap rate initially, consider these factors and review your assumptions:

• Your long-term earnings growth rate estimate may not be sustainable.
• Your discount rate should capture all risks the business is likely to face.

The typical situations that can bring your long-term earnings growth rate down are:

• Additional competition enters the market. They can capture part of the market share or put a pricing pressure on your products and services.
• The initially high growth rate leads to market saturation which ultimately reduces the business sales and earnings growth.
• Current products become obsolete and need to be replaced. Product replacement can inrease your expenses and reduce the earnings growth.
• As the sales grow the business needs to scale in order to continue servicing its growing customer base. The significant investments required may reduce the business cash flow.

Using what-if scenarios to refine your business appraisal

Since the income-based business valuation is forward looking, consider a number of what-if scenarios. Each can have a different set of assumptions regarding the business earnings and risk.

You can repeat your business valuation under each scenario then average the results to come up with an overall estimate of what the business is worth. 

If you are considering buying a small business or offering yours up for sale, the central questions are:

• What can the business sell for?
• How should I structure the price and terms of the deal?

Valuing a business to estimate its selling price

Not surprisingly, the business selling price is related to its value. Measuring the value of the business is what business valuation is about. One of the key reasons for a business valuation is to determine the market value of the business.

Company valuation using comparable business sales

Since your goal is to estimate the likely business selling price, an excellent choice of a business valuation method is to study the comparable sales of similar businesses. The actual business selling prices can be related to a number of business’ financial performance factors.

Business valuation multiples

This gives you the so-called valuation multiples. The multiples help you establish the business market value in relation to its revenues, profits, cash flow, assets or owners’ equity.

Valuing a Business using 40 Valuation Multiples

You can apply these valuation multiples to calculate what your business is worth. For example, you can take the Price to Gross Revenues valuation multiple and multiply it by your business’ gross revenues. The result is the estimate of what your business is worth - and its potential selling price.

So far, so good. If you have enough business sale comparables, you can develop a good idea of the fair market value of your business. However, every business is unique. So it is possible that your business is worth more or less than the average.

How to evaluate a business based on its earning power

Enter the income-based business valuation methods. Instead of comparing your company to others, you can determine the business value directly based on its earning capacity and risk profile.

The classical methods to do income-based valuation are the Multiple of Discretionary Earnings and Discounted Cash Flow. Both focus on your specific business and give you the business value result that is as unique as your business itself.

Valuation of a Business - Multiple of Earnings

Business goodwill valuation

If your business has been around for a while, chances are it has developed considerable business goodwill. You can calculate this important part of your business value by using the Capitalized Excess Earnings valuation method. Known as the Treasury Method, this well-known appraisal technique helps you determine the value of business goodwill and total business value.

Putting the business sale together: price and terms

Now that you know what the business value is, the next objective is to put together the terms of the business acquisition that make sense to you. Business selling price is but one element of a successful business purchase. In fact, the business sale terms often make or break the deal.

From the buyer’s perspective, the deal terms must ensure:

• Down payment amount acceptable to the buyer.
• Generous financing terms for the balance of the purchase price. 
• A living wage for the new business owners.
• Sufficient debt service coverage.
• Cash required for capital investments to keep the business running. This includes equipment purchases and working capital.
• Return on and of the buyer’s down payment, called payback.

Business cash flow must be sufficient to cover all these requirements - or the deal cannot be made. Depending on the buyer’s specific needs, the deal terms can lead to the offer price that may be well below the business value!

A strategic choice for business buyers and sellers

If you are selling your business, picking the right buyer is often the most strategic choice you can make. If you are buying a business, choosing your target carefully is well worth your while. 

Structuring Your Business Sale or Purchase

You will hear this bit of wisdom from business appraisers and brokers: small business financial statements need to be adjusted before they can be used in a business valuation. More mistakes are made in business appraisals due to incorrect earnings choices than for any other reason. 

Most small businesses are managed to reduce taxes. Not surprisingly, accounting measures of profitability such as net income are generally unsuitable for business valuation. If you need an accurate business appraisal, focus on the cash flow based earnings instead.

Business earnings basis in small business appraisals

For small businesses that are managed by their owners the Seller’s Discretionary Cash Flow (SDCF) is the typical earnings basis to use. Here is the standard definition of SDCF, accepted by the International Business Brokers Association:

• Business pre-tax earnings
• Plus total compensation for a single owner.
• Compensation of other working owners adjusted for market rates.
• Plus non-operating and discretionary expenses.
• Plus interest and depreciation expenses.
• Plus one-time or unusual expenses.

The rationale behind the way the owners’ compensation is handled is this:

Assuming the business is to be sold, all current owners are expected to depart. The buyer is likely to be replacing the principal owner and thus will take over that owner’s compensation package. In addition, the buyer will need to hire management replacement to handle the duties of the other working owners.

The questions are:

• What tasks do the current owners perform in the business? 
• What is the current owners compensation?
• How does it compare to the typical salaries for non-owner managers handling the same tasks in similar businesses?

Needless to say, the way these questions are answered can have a considerable effect on the business cash flow going forward. Some typical situations the buyer is likely to face:

• Current business owners are underpaid for the work they do. This will require that the business come up with additional funds to replace the owners. The effect is to reduce the available cash flow, and the SDCF basis used in business appraisal.
• Current business owners are overpaid relative to their contribution to the business. The excess cash flows to the new business owner after the replacement managers salaries have been paid.
• Current business owners do not contribute substantially to the ongoing operations. Their entire compensation is thus discretionary.

Effect of owners compensation on business valuation

The additional cash outlay for key management functions reduces the business discretionary cash flow. This, in turn, will lead to lower business valuation results.

On the other hand, excess owner compensation is discretionary. This increases the business SDCF basis. The result can be a higher business valuation. 

You need to have a solid understanding of what the current business owners do, who will be leaving the business, and how their compensation compares to the market rates should they need to be replaced.

Even if you do not plan to sell the business, consider the effect on future business earnings of a departing co-owner who possesses critical skills. Are these skills readily available on the market at a reasonable replacement cost? The way you answer this question can make a big difference to what the business is worth.

Classified under the SIC 5719 code, home furnishings stores are a major segment of the retail industry. If you need to value such a business, you have a choice of well-known methods to get the job done.

Perhaps the best known approach to valuing a home furnishings company is by comparison to recent sales of similar businesses. Using the actual business selling prices and financial performance parameters of such businesses, you can come up with valuation multiples to estimate what your business is worth.

Valuation multiples typically used to value home furnishings stores

Here is our list, starting with the most accurate valuation multiple:

• Business sale price to gross profit.
• Price to net sales.
• Price to EBITDA.
• Price to EBIT.
• Price to net income.
• Price to total business assets.

Since all valuation multiples are statistically calculated from a number of comparable business sales, the accuracy of each multiple depends on its spread. A tighter spread means that you can predict your business value with greater accuracy using the multiple.

Example - using a number of valuation multiples to estimate the business value

We will consider a typical privately owned home furnishings company generating $1,000,000 in net sales, $500,000 in gross profits, $75,000 in EBITDA; $50,000 in EBIT; $45,000 in net income and $220,000 in total assets.

We pick a set of reasonable valuation multiples to do our estimation:

• 0.7 times the gross profit.
• 0.4 times the business net sales.
• 5.6 times the EBITDA.
• 5.8 times the EBIT.
• 6.2 times the net income.
• 1.5 times the total assets.

Note that our valuation multiples include an estimated $100,000 in inventory.

Applying the multiples to the business financial performance numbers gives us the following set of business fair market value estimates:

• Business value based on gross profit: $350,000.
• Based on net annual sales: $400,000.
• Based on EBITDA: $420,000.
• Based on EBIT: $290,000.
• Based on net income: $279,000.
• Based on total business assets: $330,000.

Averaging all these estimates gives us the combined business market value of $344,833. As is typical under the market business valuation approach, this value figure covers the business tangible assets and goodwill. The values of business owned real estate, non-operating assets, cash and accounts receivable are extra.

Other business valuation methods for home furnishings retail stores

If you want your business valuation results to be taken seriously, consider using a number of income and asset-based valuation methods as well.  This gives you two more ways to assess what your business is worth - based on its earning capacity, risk and asset base.

For owner-operator managed home furnishings businesses, the Multiple of Discretionary Earnings method is a highly recommended choice. In addition to business discretionary earnings, this method lets you determine your business value based on the assessment of 14 key financial, operational and marketing performance factors.

If your company has a long track record of success in its market place, the value of business goodwill can be a big part of the total business value. Consider using the well-known Treasury Method in your business appraisal - an established way to value a business as a sum of its tangible assets and business goodwill.

Valuing a Business Three Ways

Ask any professional business appraiser and you will hear the same advice:

If you need a business valuation that is both accurate and defensible, use a number of business valuation methods in your analysis.

There is a good reason for this insistence - no businness valuation method is best. Each method looks at a different set of business fundamentals. This gives you a different view of what drives your business value.

If you are after a solid business appraisal that passes muster - in the boardroom or the court room - consider using several business valuation methods.

Asset business valuation tends to set the upper bound on your business value

Asset based methods, such as Asset Accumulation or Capitalized Excess Earnings, let you calculate your business worth based on its assets and liabilities.

The results tend to be on the high side, especially for asset-rich businesses such as manufacturing and distribution firms. A couple of reasons for this: some company assets may be currently underutilized. Business owners could rent out excess capacity or floor space and generate additional revenues.

Other business assets may not be currently put to their “highest and best use”. For example, business owners can license some of their technology and generate royalty income in addition to the current product sales.

Doing your business value analysis using asset based methods can help you uncover such value enhancing opportunities in your company.

Need to determine business fair market value? Consider market based appraisal methods.

Market is widely considered the ultimate arbiter of what a business is worth. Recent business sales of similar companies are an excellent way to determine the market value of your business.

In a stable market, business sellers and buyers enjoy roughly equal bargaining power. So the business selling prices tend to settle to an equilibrium - establishing the fair market value for your business.

Valuation multiples derived from such business sale statistics are a great way to come up with the most probable busines value number - the reasonable selling price somewhere in the middle of the low and high range of selling prices.

A word of caution - business market value and its theoretical “fair market value” are not the same. Business market value is the expected selling price if you try selling a business under the current market conditions. Fair market value assumes that business buyers and sellers do not enjoy significant advantages over each other and that the market conditions are stable.

For example, in stressed markets some business owners may decide against selling. Others may feel compelled to sell just to get out. Such motivated sellers are unlikely to get a fair market value price for their business. If you observe the business selling prices in this type of market, you are likely to see valuation multiples that are well below their historic averages.

Your business valuation depends on your assumptions - income business valuation

No two businesses are the same, and each business person sees the value of a given business differently. Income based business valuation methods give you the tools to determine what the business is worth to you - based on your unique expectation of business earning prospects and risk.

Business appraisers often refer to the so-called investment standard of value when talking about income business valuations. What this means is that each business person uses a different measuring stick when estimating what a business is worth.

All business valuations are forward looking. Your income forecast may be different from mine. In addition, you may assess the company’s risk based on your specific action plan.

Even if we use the same valuation methods, the results may differ. Business for sale market has a couple of well-known participants that demonstrate two extremes:

The financial business buyers are after immediate, low risk income streams. They tend to be conservative in their earnings and risk assessment. Hence, their income-based business valuations trend lower.

On the other hand, synergistic business acquirors look for unique advantages. They can envision much more positive outcomes and calculate a higher business valuation result.

    

Business Valuation based on Assets, Income, Market Comps