If you take a peek at a typical business valuation report, one of the elements that appears prominently in a separate section is the date of the appraisal.
In fact, professionally done business appraisals are only valid as of that date. Clearly, business valuation experts know that business value can change past the valuation date.
Indeed, business valuations are always forward-looking. In other words, the value of your business depends upon its earnings prospects and business risks that it is likely to face in the future.
In a rapidly changing economic environment your business value can be affected in a number of ways:
Sharp shifts in the buyer behavior as customers become more cost conscious.
Failure of key customers and suppliers.
Difficulty in raising the much needed short and long-term capital to fund business operations.
Competition from cheap or free substitutions as former customers look for less than perfect but affordable alternatives.
Such changes can dim your business’ earnings outlook as well as increase its risk. By how much? You can repeat your business valuation at any time to find out.
For example, you can estimate the decline in business earnings likely to result from the loss of a large customer. If your company relies on just a few key customers for most of its revenues, the customer concentration is a significant business risk. Should some of these customers fail or reduce their purchases, your business earnings are likely to suffer considerably.
Conversely, a highly diversified, loyal customer base reduces the likelihood that any one customer defection would affect the business earnings much going forward. Nothing is more valuable to a business in times of economic uncertainty than a steady, recurring revenue stream coming from many existing customers.
The income-based business valuation methods give you the best way to estimate how the value of your business is affected over time. For example, you can use the Discounted Cash Flow method to calculate your business worth at any point in time. Your main inputs are:
An income stream you expect from the business.
The discount rate that you build up by assessing the company’s risk profile.
You can also use the so-called capitalization methods to appraise your business. The Multiple of Discretionary Earnings method is an outstanding way to value a business based on its earnings and a set of financial and operational performance factors.
Each factor lets you assess the business risk in a specific area, for example, stability of earnings, customer and product concentration, competition and quality of management and staff.
You can use business valuation as a strategic business planning tool: implement changes, then measure their effect on your business value. Steer your business strategy to retain and grow your business worth!
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 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.
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.
Do you own a small pest control company? Perhaps plan to buy one? In either case, knowing what the business is worth is essential.
Privately owned pest control firms, classified under the SIC code 7342 and NAICS 56171, are a common service business. Established companies in this industry, especially those with a track record of positive earnings, are a frequent acquisition target.
Large number of pest control business sales = reliable valuation multiples
This is good news indeed. Recent business sales of pest control companies offer you an excellent way to estimate the value of your company. The typical method is to use the valuation multiples derived from recent sales of comparable pest control businesses.
Business price to Seller’s discretionary cash flow (SDCF).
Business price to Furniture, Fixtures and Equipment (FF&E) Assets.
Business price to total business assets.
Picking the valuation multiples that best reflect your company’s value drivers
Using a number of valuation multiples at once can tell you quite a bit about the key value drivers for your company. For example, established, highly profitable businesses are best valued using the earnings-based valuation multiples.
In fact, the business value spread is the smallest if you use the Price to Net Income multiples. This means that the business buyers and sellers tend to rely on the pest control company’s profitability as the preferred basis for business valuation in order to support the asking or offer price.
On the other hand, a young company may be showing good revenue but profits that lag behind the industry norm. In this case, the price to gross revenue valuation multiple is a better choice to demonstrate the business value.
Price to FF&E assets is another choice to value a company that has invested heavily in equipment, business automation and management systems.
Example – using valuation multiples to estimate the value of a small pest control company.
Let’s consider a typical small pest control business with the following current financials:
Gross annual revenue: $650,000.
Net Sales: $600,000.
Net Income: $50,000.
Seller’s discretionary cash flow: 140,000.
FF&E Assets: $350,000.
To calculate the fair market value of the business for this example, we pick these valuation multiples:
Price to gross revenue: 0.7.
Price to net sales: 0.76.
Price to net income: 10.5.
Price to EBITDA: 8.25.
Price to SDCF: 3.2
Price to FF&E assets: 1.4
Your business financials X valuation multiples = business value
Our estimates of the business value are as follows:
Based on gross revenues: $535,000.
Based on net sales: $456,000.
Based on net income: $546,000.
Based on EBITDA: $536,250.
Based on SDCF: $528,000.
Based on FF&E assets: $570,000.
Note that, by convention, the market value of business inventory is added to the value estimates based on gross revenues, SDCF and FF&E assets. When doing your own business valuation be sure to adjust your inventory levels to what is good and salable. Remove the inventory that is obsolete, damaged or lost.
You can use the business value estimates from above to come up with the value range or a single average number:
Business value range: $456,000 – $570,000.
Average business value: $528,542.
Incidentally, either way of concluding the business value is endorsed by the recent AICPA SSVS No 1 business appraisal standard.
See how valuation multiples derived from comparable business sales can be used to value your own company. Apply valuation multiples directly to the business financial performance factors for accurate, defensible business appraisal.
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.
Your business valuation accuracy depends critically on the correct choice of business earnings and risk assessment. See how ValuAdder financials recasting worksheets can help you handle both of these tasks.
If you are valuing a business and need to share your results with others, a professionally done business valuation report is a must. To be taken seriously, your business appraisal report needs to be thorough, transparent and follow a set of established guidelines other business people expect.
We have just released the new Business Valuation Report Builder V2.5 to give you the tools you need to prepare professional, standards-compliant business valuation reports. The fully customizable report format follows the important professional guidelines set forth by the USPAP and AICPA SSVS appraisal standards.
To make your report preparation easy, the Report Builder produces preformatted valuation report templates that you can customize in the familiar Microsoft Word editor.
Helpful comments show you what editorial changes to make and where as you work on your report. An extensive User’s Guide explains the business valuation report preparation fundamentals, gives you references to professional standard requirements and plenty of time-saving tips.
You can easily import your business valuation numbers from ValuAdder business valuation software worksheets or your own spreadsheets. ValuAdder financial recasting worksheets contain a number of data tables detailing the key elements of your business appraisal:
Historic company financial statements.
Normalizing reconstruction of financials to show the business earning power.
Risk assessment, including a 10-factor company specific risk evaluation.
Discount and capitalization rates that go into your business valuation calculations.
If you need a solid proof of business fair market value, use Business Market Value analysis worksheets to include the valuation multiples and business market value calculations into your Report Builder-generated document. This gives you a way to demonstrate what a business is worth based on a set of key financial factors: