How do I Estimate the Value of a Small Business?
Before a business changes hands, buyer and seller need to know what it's worth. There are multiple methods for estimating value such as examining a using business's earnings, its assets, or the sale prices of comparable companies. Using established methods lets you set an accurate estimate of value rather than making a best guess.
You can value a business based on assets, income, cash flow or the sale price of similar businesses. The best method may vary between different purchases.
Discounted Cash Flow
One approach is to estimate a company's worth based on its future cash flow. By plugging the business's estimated future income into a formula, you can set a value on the business in the present. For an established business anticipating steady but slow growth, the parties often use the "capitalization of cash flow" formula. For smaller businesses with uncertain income and growth, "discounted cash flow" works better, as it takes possible variations in cash flow into account. You can find the formulas online.
Price the Assets
Figuring what the business's assets, such as equipment, patents, buildings and vehicles, are worth is an obvious way to set a price on the company. However, setting a price on assets can be more difficult than it looks. A bigger issue is that a company can be asset rich and not generating much in revenue, or vice versa, so the assets may not reflect what the business is worth.
Comparable Business Sales
One way to justify a selling price is to demonstrate that similar businesses have sold recently for the same amount. Suppose you're looking at buying a laundromat. If another laundromat in the same neighborhood sold for $160,000 last month, you can assume that's what the second laundromat is worth. If there are differences – perhaps one is on a quiet side street, while the other is in a bustling strip mall – you and the seller can work out how much that should affect the price.
The income multiplier calculates value by multiplying sales revenue or cash flow. The national average multiplier for revenue is 0.6, while the average for cash flow 2.4. However, the figure for a given industry or a specific city might be different. Various business analytical newsletters and websites provide the various multipliers. Income multiplying might be a good choice if you want to set a price fast.
Which Method to Use
Different experts tout different methods, but in practice, it often depends on your individual situation. If there are no comparable business sales, for example, the comparable method won't work. If you pay for a professional appraisal, the appraiser will decide which method works best. Some industries simply accept that a particular method is right for them. Accounting firms, for example, are typically valued at annual revenue, banks at 18 to 25 times earnings. If you think a method is providing an erroneous value, don't be afraid to ask for something different.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs.