Approaches to Valuation of Small Businesses

Updated on March 1, 2019
Glenn Hopper III profile image

Glenn Hopper has worked as an SMB CFO in multiple industries for more than a decade. He has a background in finance and analytics.

Financial Valuation of Service Businesses

Whether evaluating a business for purchase or looking to sell, it is crucial for small and medium-sized business owners to understand the fundamentals of business valuation.

A common misconception of small business owners is that their company’s value is based on how much money they’ve invested in it. While this may be a more accurate assessment of the value of an asset-heavy business, it does not take into account the present value of the business assets and the potential future return.

Asset-based valuation is especially unreliable in service businesses.

The value of an architecture or accounting firm, for example, is not tied to how much the current owner has invested in the business. The value of the business is in the services they offer to clients. Unless the potential buyer only wants the real estate or other assets, the purchase price will be set by a combination of other criteria, including revenue and earnings history, cash flow, market share, market comps, growth opportunities, and the value of current management and employees.

Many business purchases are valued specifically as a book of business (i.e. the company’s greatest asset is its customer base). Asset-light businesses with a steady recurring revenue stream and long-time clients are often sought after by existing businesses with an acquisition strategy. Beyond current clients, potential buyers also look at the value of any intellectual property (IP) or other intangible assets the company owns.

When determining the value of a business, it is important to look at the full financials: The Balance Sheet, Owners’ Equity, Income Statement and Statement of Cash Flows. From these financial statements, buyers can get a full picture of the nature of the company’s operations.

  • Balance Sheets show a company’s assets (tangible and intangible), short- and long-term liabilities, and owners’ equity.

  • The Income or Profit and Loss Statement shows a company’s revenue, expenses and income.

  • Cash Flow Statements show all cash inflows from ongoing operations and investment sources plus cash outflows related to financing business and investing operations.

From these financial reports, analysts and potential buyers can use ratios to gauge the true value of the business. Some example ratios that help in business valuation and analysis are the company’s debt-to-equity ratio. While the previous owner’s financing is irrelevant to the new owner’s financing position, it is important for potential buyers to know if the previous owner was saddled with debt that would influence the asking price. Perhaps the key ratios are the company’s profit and income margins. Profit margin (net income over net sales) shows how profitable a business is relative to its total revenue. The acquiring business may believe that by integration the purchased company into their operating model they can drive greater margins. Or conversely, they may be looking to purchase the business to benefit from the production efficiencies of the acquired company.

Other key ratios to consider include Asset Turnover, which measures a company’s ability to generate sales from its assets. Quick and Current ratios are measures of a company’s solvency. Is the company able to pay its current and long-term liabilities?

For both buyers and sellers, it is important to know what is being purchased. What is the most valuable asset? In other words, where does the business’s real value lie?

The answer to this question will help determine the best valuation method to use.

Business Valuation Methods

Asset-Based Valuation

This is generally the lowest possible valuation for a business owner. Asset-based valuation does not take into account the value created by the business. Asset-valuation is simply the total value of the company’s assets minus its liabilities. Asset-based purchases are generally used when a company’s real estate is more valuable than its operations or when an owner is forced to liquidate in a “fire sale.”

Market-Based Valuation

Similar to real estate purchases, market-based purchases determine a business’s value based on comps from recent similar purchases in the same industry. This approach is a valid one; however, it can be very difficult to find information on the sale of private companies. It also does not take into account specific value of the target company. For example, a company that is growing faster than the industry average or has a uniquely valuable production process would garner a value higher than the market rate.

Earnings-Based Valuation

Company earnings are the bottom-line best measurement of a company’s value. Regardless of the sunk costs of previous investments, the future value of a business can best be determined by how much cash the business spins off. Some very simple business valuations are based on a multiple applied to a company’s earnings. This multiple varies across industries and business sectors, but in general the multiple typically ranges from one times current earnings for very small businesses where the owner is the sole producer to as much as ten times earnings for an exceptionally strong business with large market share and growth potential.

Discounted Cash Flow

The most sophisticated approach to business valuation is to consider a company’s potential return vs. any other investment. If a buyer can achieve a greater rate of return from investing in the stock market or cryptocurrencies, it would not make financial sense to purchase a business. Of course, in valuing a business, any potential investor would also factor in the risk associated with the investment. They will, therefore, weigh the risk of the business and potential for return vs. an alternate investment. If the stock market average return is 7% or the risk-free rate of T-Bills is 2.4%, how does that compare to the potential return from the business?

The Discounted Cash Flow (DCF) method calculates the present value of a business’s future cash flow, discounted by the business risk. DCF considers the future value of money. If $100 can be invested today at a 5% annual interest rate, that $100 will be worth $105 in one year. And a promise to pay $100 in one year is only worth $95.24 today.

The Discounted Cash Flow formula is:

Where:

CFn = Cash Flow for each year

r = the discount rate

The discount rate is the rate the investor requires from the investment. This could be the estimated return of an alternate investment or the risk-free rate.

From this, future value of an investment can be calculated with the formula:

By calculating FV, an investor can determine the value of an investment at any point in the future.

Calculating the future value of an investment and its discounted cash flow gives buyers or sellers a simple estimation of the business valuation in context of other investment opportunities.

(Note: This is a very simple look at DCF. In more complex valuations, investors would take into account the future value of the company's assets or cash flows, rent payments and other variables.)

Putting it All Together

“An investment in Knowledge pays the best interest.”

~ Benjamin Franklin

The value of a small business is greater than the dollars and cents of its valuation. Unlike large and publicly traded companies, small businesses are intertwined with the daily lives and livelihoods of their owners. It can, therefore, be difficult for owners to ascertain the true value of their business. But with the help of the few simple tools included in this article, business owners can objectively evaluate their companies’ worth.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

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    © 2019 Glenn Hopper

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