There’s no one way to value a company, and the final answer usually involves a mix of quantitative and qualitative factors. Here are some of variables you might want to account for in your valuation process:
- Value of the assets. Add up the value of everything the business owns, including all property, equipment, and inventory. Subtract any debts or other liabilities. This gives you the net asset value of the business — what it would be worth if you liquidated everything and turned it into cash. This is a good place to start, but it doesn’t account for the additional value created by revenue and earnings.
- Revenue calculation. The revenue generated by a business is another key metric to account for in its valuation. Although it does not reveal how profitable the business is, in established industries with predictable profit margins, business valuations are sometimes expressed as a multiple of revenue – say two or three times annual revenue. An experienced advisor can guide you on the appropriate multiple for your industry.
- Earnings multiple. Valuing a business based on a multiple of its earnings is typically more revealing than using a multiple of its revenue. For one thing, it measures the net earnings after expenses, which provides a truer picture of profitability. For another, it tends to be forward-looking, based on earnings expectations. For example, if a typical price-to-earnings (P/E) ratio is 10 times earnings, then a business that is expected to earn $300,000 per year is worth $3 million.
- Discounted cash flow. A discounted cash flow analysis looks at the future cash flow expected from a business and discounts it to today to arrive at a net present value (NPV). This formula makes it possible for a potential business buyer to understand whether an investment in the business is likely to pay off over time, given the cost of borrowing the capital to buy it in the first place. There are free online NPV calculators to assist with this analysis.
- Strategic considerations. There are many strategic nuances that can modify the value of a business. For example, is it an early entrant into a high-growth industry? Does it have a unique competitive advantage? Is it geographically positioned in the ideal place? Would it have particular strategic value or special synergy for a specific acquirer?
You may also wish to consult a business broker or professional business valuator to help you focus on the most relevant factors for your situation.
Key considerations when valuing a business
When valuing a business, the data inputs and the valuation method are two main considerations.
- Data inputs will typically include things such as financial statements for the past several years, the most recent tax return, details on discretionary and non-recurring expenses, management compensation, staff and payroll, details on customers and suppliers, details on property ownership or lease, and legal issues such as patents, bylaws, and shareholder agreements.
- Valuation methods are often blended together, and can include asset-based calculations (what the company owns), earnings-based methods (what the company is likely to earn in the future), and market-based methods (what multiple of future earnings is appropriate given the characteristics of the business and its competitors).
Value of assets
The value of a company’s assets net of any liabilities is referred to as its net asset value or book value. This number is seen on the company’s balance sheet. In some ways, this is the foundation of a company’s value, because it represents the amount of money that would be left if the businesses ceased to operate today and everything was sold for cash.
While the balance sheet of a business can provide a good snapshot and serve as a starting point for calculating its value, it is usually not enough to establish a robust valuation. For example, while some assets (like real estate) could be appreciating in value, other assets (like equipment or inventory) could be losing value. Meanwhile, if the company is not profitable, it could be continually increasing its debt.
Revenue refers to the money coming into the business. It’s the “top line” of the business, as opposed to the “bottom line,” which subtracts all of the expenses associated with running the business.
Strong and growing revenue is a good sign, and in some industries, where profit margins are predictable and stable, the value of a business might be established based on a multiple of the revenue.
For example, in some mature industries, a business with $500,000 in annual sales might be valued at two times revenue, or $1 million. If the business also owns assets, those might be added to its total valuation.
Stock market investors have long used the price-to-earnings or P/E ratio as one of the main ways of valuing companies. For example, if a company has $1 million in annual earnings and one million shares outstanding, that means there is one dollar of earnings for each share. If stock market investors are optimistic about the company, its shares might trade at a P/E ratio of 15 times earnings, or $15 per share. When you multiply that by the one million shares outstanding, the entire company is worth $15 million.
This same approach can be applied to a private business. If you know what the annual earnings are expected to be and what earnings multiple is typical to that industry, you can multiply out the total value of the business.
Cash flow analysis
Cash flow analysis is based on the net present value (NPV) of future cash flow. It is based on the principle that receiving one dollar of cash flow today is worth more than receiving it at some point in the future, especially if it comes from an investment that you made with borrowed money and must pay interest in the meantime. Cash flow analysis tries to assess what the business is worth today based on the cash flow it will provide in the future, net of the cost of borrowing the capital.
How to value a company beyond financial calculations
Some of the most successful business stories are those where the buyer or founder of the business was able to spot value that wasn’t necessarily obvious just by looking at the assets, revenue and cash flow. You might ask questions like, what is the future of the industry? What are the competitive trends? What can this business do better than others? Does it have strategic advantages? Are marketing or distribution breakthroughs possible? How will external factors like technology, regulation or demographics help its future prospects?
Business location and proximity
Location and proximity can affect the prospects of a business in many ways, so think it through when considering your marketing needs, talent acquisition, and operating costs.
In industries like retail and hospitality, location is crucial for attracting customers and capturing walk-in business. In industries like science and technology, location can have a big impact on the ability to attract employees with the right skills and education. For industrial and e-commerce businesses, proximity to the right suppliers or shipping and logistics support could make or break profit margins.
Strategic value is usually a function of synergies between a company and a potential acquirer. These synergies can create added value. For example, a company that makes special parts could have strategic value to an industrial company that would save on production costs by acquiring it. Or a consultancy that specializes in a specific industry could have strategic value to a business within that industry that would gain unique intellectual capital by acquiring it.
Bringing this all together
The value of a company should reflect its financial performance, its unique qualitative attributes, and its external environment. And, because of the potential for unrecognized value or unique strategic value, its ultimate price will be in the eye of the beholder. As someone who wants to buy a business, you will need to consider your personal objectives and all of these factors to arrive at a valuation that makes sense for you.