Top Business Valuation Formulas
I just returned home from a speaking engagement in Las Vegas. The presentation was titled “The Elephant in the Room” and was all about succession planning, exit strategies and the need to have both in place. It was about your responsibility as leader to ensure your business is as profitable as you can make it so you have something of value to sell when the time comes.
It sounds logical enough, and yet, it is estimated that fewer than 20 percent of all businesses have made the effort or invested the time necessary to create either a succession plan or an exit strategy. Even if you aren’t thinking about exiting the business any time soon, determining what your business is worth is a critical exercise you can use to keep score of where you are and where you need to be. This can be especially helpful if you are re-organizing, re-financing or preparing your estate.
To help you understand, here is a brief explanation of the five most common valuation formulas:
The presumption here is your business is worth at least the number shown as owner’s equity on your balance sheet. It is neither the most popular nor the most accurate method because it generally uses depreciation and historical costs, rather than current market value.
There are mitigating factors, however, that can be used to impact the asking price, like the fair-market value of the equipment, leasehold improvements that essentially become part of the property, and discretionary cash.
This could be the basis for a bare-minimum asking price for your business and/or the starting point for some serious negotiation.
Assets and Earnings Valuation
This is the prescribed method most commonly used by the IRS when they valuate a business with estate and/or gift tax issues and many accountants gravitate toward it if they feel the valuation may result in an audit.
It starts by recasting your financial statements to show the business without your salary, perks, and benefits and should probably be averaged over a 3–5 year timeframe.
The starting point for this valuation method should be the net value of your assets as they appear on the recalculated financial statement.
Capitalization of Income Valuation
This method of business valuation is more appropriate for service-related businesses because it is focuses on a number of variables that are far more intangible in nature than the physical assets of the business.
These intangibles can be listed and then assigned a rating based upon a scale of one to five, with five being the highest rating. The average score can then be multiplied by the buyer's discretionary cash to establish market value. These factors can range from:
- Owner’s reason for leaving the business
- Years of continuous operation
- Degree of risk associated with this type of business
- Growth history
- Barriers to entry
- Customer base
If you add up the total of the ratings assigned to each topic and then divide by the number of topics, you will have a number that you can use as your capitalization rate. This number is then multiplied by the buyer’s discretionary cash and the result can be considered the market value.
Owner Benefit or Historical Earnings Valuation
The owner benefit method utilizes a standard multiplier of 2.2727, which is based upon a 10 percent return on investment for the buyer, a living wage equal to 30 percent of the owner's benefit, and a debt service of 25 percent.
Historical earnings valuation is based upon both the assets of the business and the goodwill. Once again, this method is based upon a set of recast financial statements with the owner's salary, perks, and benefits removed.
These calculations begin with the company’s net earnings, including a reasonable owner’s salary minus capital improvements and working capital increases, with the depreciation figured back into the equation. You then multiply this number, which is generally referred to as free cash flow, by the number of years it will take to pay off the loan required to purchase the business. Subtract the down payment, and what remains is what will be left to make interest and principal payments on the loan, plus a moderate return on investment for the new owner.
Multiplier of Market Valuation
The problem most people have with this method is that it does not reflect just how different two businesses in the same industry can be. It is based upon what businesses like yours have recently sold for and is generally figured as a multiple of gross sales.
The formulas can use a multiple of anywhere from 0.75 percent to 1.5 percent of annual net profit plus inventory and equipment in a retail business.
To determine what the correct multiplier is for you, call your local association headquarters or a broker specializing in the automotive service industry.