How much is my business worth? How do I value a business? How can one determine the value of a private company or a small business? These questions are commonly asked by business owners, as well as people who are looking to buy a business.
Although the answers are not always easy to determine nor is there a simple answer. In this article, I want to try and give you more insight into the challenges of determining value.
Why it is not easy to determine a value? Then, we will look at some of the methods available and how they can give some insight into a business’ value. Additionally, we will see that each method or formula for determining a business’ value has weaknesses. In the final part of this discussion, we will see why a mixed methodology or a range of values may be the best method for determining how much a business is worth.
The Challenges of Valuing a Business
Before we get too far into how to value a business, it would be helpful to review how the value of anything is determined. How much is something worth? That question sounds like an easy question to answer, but the reality is that valuation and price is a much more difficult point to determine.
In basic economics, a price point is determined by developing a Supply and Demand Curve, with the price point being determined where the two curves meet on a graph. It is quite simple, easy to comprehend, and elegant from an academic point of view. The practicalities are much vague and more open-ended.
The economist looks at the data and will quickly determine the price point, giving rationales based on things such as the propensity to consume or theories on substitutions. Of course, in reality, the simple value is whatever anyone is willing to pay and the current owner willing to accept. This is one of the main reasons why price or value is difficult to determine.
For example, let’s think of a can of tuna fish. We’ll say the can is priced at $1. The maker of the can of tuna fish has calculated all their costs into each can.
They have added in everything from the costs of a ship and crew going out to sea to catch the fish to processing the fish, cooking and distributing it to the grocery store. Then the grocer adds their costs into the can as well. Such as storage fees, employees to stock/sell the can, and marketing costs of the can.
However, regardless of all the costs added into the can; it will only sell if there is a person willing to pay $1 for the can. For the buyer, the value is only $1 if they are willing to pay that much for the can. The buyer does not care about the costs added into the can of tune; just what they get out of the $1 spent for the can.
What Else You Should Know
This example demonstrates the one issue that is often overlooked in the pricing of anything. The value is often in the eye of the buyer. The only way that anything has value is if a willing buyer is ready to pay a specific price for the item. They have either a need or a more likely a want for the item. In fact, today it seems as if more people are placing more emphasis on buying their wants rather than their needs.
Let’s consider another example to demonstrate how buyer’s wants influence value. All cars do the same thing, move a person from one point to another. However, the value or price between a Lamborghini and a Honda is huge. With all due respect to the makers of both cars, the main reason for the difference is the wants or value that the buyer places on the cars. Yes, most people would take the more expensive car if they could afford it and that is because of their wants rather than needs.
The importance of “want” in determining value cannot be emphasized enough. Real estate is an excellent way to demonstrate this concept.
Some of the most valuable real estate in the country is in New York City and San Francisco. However, there is a percent of the population who would not put any value on living in either of those cities. To this segment of the population, property in these locations would be nearly worthless. In other words, they would not buy property there, even if it were very cheap.
The same is true for the sellers. There are a percentage of sellers out there that would not sell their property for any price offered. Their attachment to a piece of property is such that they cannot be adequately compensated for the personal attachment to the property. Thus, you can see that price or value is not easily determined because of peoples’ emotions or attachments to things.
How to Look at the Business Valuation
However, living in the real world, we all know that price or value can influence a person’s emotions regarding a thing. People can be motivated to buy something because the price is just too good to pass up.
If a property on Madison Avenue was for sale for only $1, it would be hard for anyone to pass it up. Thus, price can motivate people as well as wants. This is because they have an innate idea of value and will buy because of a great “deal” even if they do not want the item.
In discussing general values or prices, one more item must be considered and that is an active market. Using our example of the can of tuna, we know that prices of the can are relatively stable. This is because there are an active market and people do not have to negotiate for the can of tuna.
In the case of cars or houses, there is an active market as well. However, pricing for these items does vary to a degree. This variance is due to the fact that these prices are often determined by negotiations. In fact, because of the active market, price can be readily determined.
For examples, if 20 homes sell in a month and they are all relatively equal in quality; then the average price is quick to find. This concept is one of the main reasons real estate agents will use comps to determine price. By using comps, the realtor can quickly determine an average price for a similar home in a specific area.
However, a problem arises when the is an inactive market. An inactive market is one where there is little or no sales in a given period of time or there are no equal sales in a period of time.
The Example and What to Expect
Using our comp example above, what would happen if those 20 homes sold over a period of 5-years. The comparable sales method for price, comps for short, would not be accurate. Because the sales occur over such a long term, there is too much variance that can influence the sales and thus disrupt the accuracy of the price point.
The same issue can be applied to business sales for determining price. There are fare fewer business sales when compared to home sales in any location. Because the sales are low, comps to determine value of a business is limited. Yet, because so many business brokers are real estate agents or come to the business brokerage industry from the realtor space, they do rely on comps to determine value and price.
Another factor that negatively influences comp sales for determining price is comparability of the business. We touched on this above, as not all businesses are the same. Obviously, a hair salon and a machine part manufacturer are not the same type of business and valuations for these businesses would be useless to compare to the other.
In fact, even some of the most readily available businesses for sale are restaurants. However, looking at values or prices for these businesses will show quite a range of prices, even for restaurants that have similar menus. This is one of the biggest challenges of determining a value for a business for sale- no 2 businesses are alike.
Things You Need to Consider
Finally, to build a bit more on no 2 businesses being alike, we need to keep in mind that businesses are income producing. Income is produced not only by tangible assets but through intangible assets.
Tangible assets are easy to comprehend and give a reasonable value. For example, a manufacturer that makes phone cases has to use plastic or physical raw materials to build the case. This value for the inventory of the raw material is easy to determine. However, add in an intangible, say a specific method of making the case that speeds up the building process. This intangible manufacturing method is harder to value. Yet, the method is a major asset of the company because it increases their competitive advantage.
Intangible assets are the most often overlooked assets of a company, because they are thoughts, ideas, concepts, experiences, as well as other intangibles. How can one place a value on those assets? It is a challenge even for professional consultants like myself who are advising clients what something is worth.
Indeed, intangible assets may play an important part it valuing a business when combined with a buyer’s point of view as well. For example, if one buys out a company because they have a better facility for producing a product, they will also bring their production experience to the new purchased company. This better facility could drive more efficiencies, thus make the new business even more valuable and cause the buyer to place a higher value on the business being purchased.
From these examples you can see why there are many challenges in placing a value on a business. In the next few sections we will look at some reasonable processes, or formulas for determining a business’ value. But each will have their limitations based on the ideas from the challenges.
Different Methods of Valuing a Business
Now that we have examined some of the challenges in determining the value of a business, let’s look at some of the methodologies that are used to make these values.
It is worth noting that these methodologies, as would be understandable from discussing the challenges are more of a guideline. Each has its own deficiencies in determining an accurate value. However, each has positives that are based in reason and logic to give an owner or buyer an accurate view of the value of a business.
Additionally, these formulas or methods for determining value will be more valuable to some business than for others. For example, an asset-based valuation would be more helpful to a company that has tangible assets, than, say a business that has a high value in goodwill. Goodwill is often an assessment of the intangible assets of a company.
The asset-based method is one of the easier and more basic methodologies for determining value. It is simply adding up all the assets of the company. These are usually tangible assets, but may include intangible assets as well, depending on the company and business.
Next a person will add together all the liabilities of the company. These liabilities are the debts, accounts payable, and other liabilities. Then to determine the value, one will subtract the liabilities of the company from the total of the assets, arriving at the value.
As an example, suppose a company has $20,000 cash in the bank, a building worth $130,000, a small fleet of vehicles worth $25,000, and $25,000 in inventory and machinery.
On the debit side, let’s presume that the company has a mortgage of $85,000, a working capital loan worth $17,000, and accounts payable of $40,000.
The company would have a total asset base of $200,000. Total liabilities would be $142,000. Thus, the company would have a value of $58,000.
Looking at those numbers, it might have entered your mind that there are issues with this methodology. First, it could be argued that the company is worth $200,000 as the company’s total assets add up to $200,000. However, someone, either the current owner or a new buyer, will have to pay the debts of the company before it can sell. Second, just looking at the data, this valuation could be described as wanting, as it does not add any value for changes in assets and debts.
These numbers are fixed at a specific moment in time. For example, what if the following day that these numbers were used, the company received a new account with a retainer that paid down the accounts payable? What if the company just bought a new vehicle to add to its fleet? If the difference in loan and vehicle value is upside down, then the assets are negatively impacted. One of the problems with any financial asset-based valuation is that they are often a snapshot in time, just a financial position of the company on a particular day.
Another downside to this type of analysis is because of the static nature of the assessment. This methodology does not allow for any change in operations. It does not take into account changes in sales, innovations in operations, nor a change in management. Thus, as a formula for determining a business’ value it is only a quick static view of the company.
These issues are the primary downside to using an asset-based valuation, it is only a specific snapshot of the company and does not account for changes in financial operations nor position. The asset-based value might be best viewed as only a starting point in placing a value on the business.
The revenue model valuation method is actually comprised of several methodologies, with each attempting to place value on the business based on its income. The main advantage in using this methodology is that it accounts for the business operations, giving it value as a going concern.
The main difference between businesses and other asset classes is that the business is actually supposed to be producing regular income streams. Yes, there are a good number of businesses that go public without making a profit, but most have income streams. Thus, it is easy to see why this is a better method to determine the value of a business or developing a formula to place a value on a business. In may ways this is simply a value based on the sales of the company.
So how does this system work? Well, the details are where the weaknesses of this methodology can be seen. Let’s look at an example:
Let’s presume a hair salon has been open for 20 years and the revenues of the company are about $250,000 per year with the owner making a steady income of $75,000 per year. A pure sales-based formula for value would use the $250,000 and base value on the business built on this number, as it is based solely on revenues or sales.
However, let’s look at those numbers a bit more in detail. What if the $250,000 income is actually the smallest gross revenue amount the company has earned in 20 years. Therefore, the revenues are declining over time.
Is that a good value to place on the business? Maybe, maybe not. What if the company just lost three of their best hair stylists? Will the revenues still be that valuable? Suppose the owner is the only worker at the business. What happens when they leave, will the clients still keep coming?
How Accurate is Revenue Model Business Valuation?
The above questions explain the weakness of a pure income-based valuation method. The limitation is that there are many variables that affect the sales or revenue stream of a company.
Some variables that can affect revenues are some of the following: There could be salespeople that are superstars in the company for one or 2 terms. When governments change some of their regulations, there can be a quick surge is some sales. For example, when a state changes their smog requirements for car emissions, the businesses that perform smog testing may have to change their smog machines. The companies that sell smog machines to these businesses will likely see a strong surge in sales, only to have the sales taper off as these businesses deploy the new machines.
You can see the major issue with income-based, sales-based, or revenue-based valuation methods is that it is still more of a snapshot of the company at a moment in time. It is very much like the asset-based method just using different data points as its starting place. The main issue is that it captures sales over a short period of time, without the benefit of examining sales results over a longer time period.
Discounted Cash Flow and Similar Methods
Now that we have indicated the defects of 2 methodologies for determining a business’ value, you are probably wondering is there any way to place a value on a business?
Let’s look at one of the biggest investors in the world, a company that purchases companies on the stock market. One of the best-known buyout artists is Warren Buffet.
Through his company, Berkshire Hathaway, he has built a huge empire of businesses in the world. You have heard of some of his companies- Dairy Queen, Burlington Northern Santa Fe Railroad, Geico Insurance. Yes, Berkshire Hathaway has been a great company at looking for value in companies that it can buyout.
The secret to Berkshire’s success is that they use a discounted cash-flow analysis. This is a classic valuation method for determining an operating business’ value over the long term. The method is to take a year’s earnings extrapolating that out over a term of years. Then you discount the cash flow and compare the rate of return to the rate of return for US Treasury bills.
The idea is that you can compare how much you will make for a period of time and compare it to what you would make investing the same money in T-bills or other safe investments. The formula of this method is the Net Present Value of money.
Okay, you are probably thinking, but will that help me place an accurate value on a small business. The simple answer is no.
Discounted cash flow works well for large investments and as a means to compare investments. However, when it comes to analyzing value for a small or medium size business it is weakened by the fact that income is not stable and often differ greatly year over year for smaller businesses.
The logic is simple. A small business operates on a different level than large businesses. Large businesses often have stable incomes as they have long term contracts and clients. Even a large retailer, say Walmart or Target, who do not have contracts, have more stable incomes because of their size. Basically, this is an advantage of brands; they are known and will have a steadier flow of income when compared to smaller business as their sales base is larger.
Stream of Incomes
One method that works to try and place a value on a business using a steadier income flow is a stream of income method.
The method simply looks at the business’ income over a period of time and then use that as a method to determine the company’s value. The benefit of this method is that it gives value to the business based on a series of earnings and this corrects one of the shortcomings mentioned above- an unusual event that skews the earnings.
The method spans earnings over a period of years to make up for earnings that are not steady. The value is that it allows the business to be valued based on real earnings for several years and should correct any fluctuations.
If one chooses to use this method, they do have more options as to how to develop a final valuation. Because the valuation is based over a number of years the person developing the value can base it on two years or twenty years or more. Because the method is based on the average of streams from revenue over time, it allows for changing up the time frame.
It might have entered your mind that couldn’t this lead to a hyper-inflated value of the business. The simple answer is yes. Let’s presume that a company has earnings of $200,000 per year and one adds up five years of earnings, this would imply a value of a $1,000,000. Is the company worth that much? Maybe, maybe not. That is the problem with the stream of incomes, it gives some insight, but it is not always accurate.
One shortcoming of all of these analyses is that they presume the value to be static. Yes, the stream of incomes method does try to tackle this issue by looking at earnings over the long term to determine value. However, due to using past performance earnings, the analysis is just looking at how the company has performed in the past.
For a business buyer this could be overstating the value of the business as it’s not based on their management skills. For the seller it is lacking in that it could understate values of the company’s performance if the company has not been performing at optimized levels. Thus, while these methods can give some idea of value it is not the end all to placing a value on a business.
After examining these examples, it is clear that to place a value on a business using several of the common methods is not an easy solution to find the worth of a business. Each method or formula has merit and is based in logic. But the issue is can it place an absolute value on a business. From the examples above the answer is that they cannot place an absolute value as each has a weakness.
The Range of Values For Potential Buyer
So, what then should one as a business owner or potential buyer of a business do? It would be best if you need to have a solid value for what a business is worth. It has to be based in logic and take into account that valuation will differ.
Perhaps the best method and one that many consultants encourage, including myself, is to develop a range of valuations and use this as the basis for placing an actual value on the business.
The range method combines each of previous methodologies and an owner or buyer can add-on other values. For example, the owner who knows that a business has been lacking can indicate that with better management, the company could be making more and hence increase the value.
The same is true for a buyer; they can see underperforming assets in the company and know that they could make it a much more valuable enterprise. In fact, there are plenty of stories of people that specialize in this arena- Lee Iacocca, Carl Icahn, and plenty of others have made empires buy buying underperforming companies or assets and turn them into highly profitable and valuable businesses.
What is the range methodology? The owner or the buyer of a business looks at everything from the asset-based valuation to stream of income, determining a range of valuation based on each of these methods. Once this is accomplished, then the person will look at these values and realize that the most likely value for the company will fall within this range.
The benefit of the range methodology is that it attempts to determine the value based on all of these methodologies, while not placing any emphasis on one over the others. The hope is for the true value of the company to be somewhere in this range.
As an example, let’s presume there is a restaurant that is getting ready to be placed on the market. The company has been averaging $200,000 in revenues for the last 10 years, but the last 3 years the owner has not been as involved in the company, so earning are below average. The assets of the company are as follows: building $250,000, equipment $15,000, fixtures $10,000, cash $25,000. The debts are: $10,000 mortgage on the building, and a working capital loan of $25,000. In the most recent year of revenue the company earned $95,000.
- From the asset-based value the company would be worth: $300,000 (total of assets) minus $35,000 (total of debts) equaling $265,000.
- From the revenue model the value is $95,000, the most recent year of earnings.
- From the revenue stream the value is $200,000 with maybe a little bit shaved off for the last few years.
- The range method then would say that the value of the company would be somewhere between $95,000 and $265,000. This range allows for a more accurate value because it is not fixed and the owner or buyer could increase or decrease the value based on their ideas as well as their opinion of value in the business.
What is the bottom-line in finding a value to a business? The best answer is that it is complicated.
First, the business value is highly dependent on the eye of the buyer or the seller. Recall that one of the main determinates for value is the emphasis that a person places on their want for the business. Personal views will always have a big influence on the ultimate value of the business and may not always be based in logic.
Second, there are multiple methods or formulas for determining value. Whether it is the asset-based, revenue model, or a discounted cash flow; each has merit, but each has faults, meaning that neither is a perfect method for determining the value of a business. This is why the best solution is to use a range of value to place you in the “ballpark” for what a business is really worth.
The main benefit of the range of value is that one can look at many different methods and mixing the results with other add-ons from each person’s perspective (their want, ideas on managing or improving the business, special skills they can bring to the enterprise, etc.) The range gives one more latitude in determining price, but allows the underlying value to be based in logic and reason.
Good luck in valuing the businesses that you look at and feel confident that these rules will help you determine a reasonable value for those businesses.