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How to Value A Business?

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How to Value A Business?

How much is my business worth?

By understanding your business’ true value, you can optimize your profits.

If you find yourself asking this question, you’re probably interested in:

  • Cashing in your company and want to sell it at the highest possible price.
  • Calculating your assets and tax liabilities.
  • Watching your business grow in value grow over time.
  • Planning for retirement by estimating your company’s future sale price.

You can estimate your business’ total value with a huge variety of techniques – and from many perspectives. In this post, you’ll discover many of the most popular and potent evaluation techniques for corporate valuation.

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How to Calculate Business Value with Asset-Based Methods

First, list the values of all fixed assets owned by your company:

  • #1 Real estate properties

  • #2 Stocks and other investments

  • #3 Equipment and machinery

How to Valuate Your Business with Earnings Multiples

If your company has a substantial financial history, you can use its Price/Earnings (P/E) Ratio to evaluate potential sales prices. You can use this formula to determine the relationship between your business’ value and profits:

Price/Earnings Ratio = Price Per Share / Earnings Per Share

Before using this formula, you need to know your business’ Earnings Per Share (EPS). Accountants typically calculate this figure from a company’s earnings numbers from the previous four quarters:

Earnings Per Share = (Income - Dividends) / Shares

That’s enough theory for now – let’s get practical. Imagine you own a company that creates virtual reality goggles for gaming enthusiasts and want to know how much you could make by selling your company. Would you have enough to retire and spend the rest of your days in a virtual reality?

Let’s say your VR goggle business earned 1 million dollars (after taxes and expenses, of course) over the last four quarters. It paid out 100,000 in dividends and averaged a total of 300,000 shares (For the sake of simplicity, let’s say you and your family own 100% of this business’ shares.) Your earnings per share would equal $3:

EPS (3) = (Income [1 million] - Dividends [100k]) / Shares [300k])

If your share price averaged $12 over the last 4 quarters, your Price/Earnings Ratio would equal 4.

P/E Ratio [4] = Price Per Share [12] / Earnings Per Share [2]

Now, imagine one of your top managers has amassed a fortune playing online poker and has offered to buy your company for 10 million dollars. Is this a good deal?

Remembering that your company made 1 million dollars over the last four quarters, you determine that the P/E Ratio of this offer equals 10:

P/E Ratio [10] = Price [10 million] / Earnings [1 million per year]

Since 10 is greater than 4, this sounds like a good deal, right? You’d certainly make a lot more money in the short term by selling the company and plugging in your VR headset than by continuing to run your business.

Consider that if you put in another decade running this company, you’d make 10 million and break even with this offer. So, is it worth retiring yet? Should you stick it out longer, work to increase your P/E Ratio, and retire later with even more piles of cash?

This personal decision depends on your expenses, remaining work years, future ambitions, etc. Financial experts typically estimate companies’ P/E ratios at 4 to 10 times their annual profits, so an offer of 10 million for a company that makes 1 million a year seems quite good. However, if it were me, I’d hold onto this lucrative business a good while longer.

Valuation Using Comparables

You can also use P/E Ratios to compare your company to others in your niche. However, take this with a grain of salt – many factors affect these numbers. For example, high-tech/IT companies often have higher P/E Ratios than traditional businesses. Startups and other rapidly growing businesses have high P/E Ratios but may carry risks that decrease their true values over time. Well-established companies may have lower P/E Ratios but represent much sounder investments.

Small businesses that make most of their profits from one product experience more vulnerability to market forces than larger, diversified companies. If you’re selling today, consider the likelihood of a better offer arising in the current economic climate. If you’re planning for retirement, consider your business’ future value and long-term economic trends.

Finally, take any P/E numbers you get from financial news outlets with a big grain of salt. As you can see above, these numbers offer a limited perspective on corporate value, at best.

Free Cash Flow Methods

When selling your business, take care not to turn away good offers. Let’s reconsider the previous 10 million offer for your VR goggle company, which makes 1 million dollars a year. Let’s say you work full-time in this business, take an annual salary of $100,000, and drive a company car with a yearly lease of $10,000.

You can get a more accurate idea of your company’s value by considering your personal financial interactions with your company and a variety of other factors:

Business Value = (Annual Income - Owner Salary + Owner Expenses) x > Multiplier

Since you will stop working for this company when you sell it, someone needs to fill your shoes, to the tune of 100k. However, in this economy, the company doesn’t need to offer this person an expensive corporate car as a perk. Let’s say a multiplier of 10 is appropriate in this example because your free cash flow has increased over the last few years and industry experts expect VR goggles to continue growing in popularity. (If applicable, also add in the value of all property your business owns and subtract any outstanding debt.)

After considering your free cash flow, your company is worth 9.1 million, not 10: Business Value [9,100,000] = (Annual Income [1 million] - Owner Salary > [100,000] + Owner Expenses [10,000]) x Multiplier

Option-Based Valuation

Your company may have the potential for unrealized future profits. If you only use valuation methods which examine your past performance (like the ones above), you could dramatically undervalue your business. With option-based valuations (similar in logic to stock options), you can suss out your business’ true value over time.

Use option-based valuation to determine the value of a new owner’s “option” to exploit your company’s properties, patents/copyrights, and other resources in new ways. For example, say the manager who bid 10 million on your business knows your R&D department has recently discovered a new scent-based Smell-o-Scope technology that will make VR more accessible and bring it into the mainstream. How does this affect your company’s value – and the fairness of their offer?

Let’s say this new technology, once exploited, will quadruple your company’s profits. However, to produce this cutting-edge product, you will need to invest 20.1 million in new facilities, equipment, and software.

After considering free cash flow, you estimated your company’s value at 9.1 million. However, if you (or the buyer) developed this new technology, your annual income would jump from 1 to 4 million, dramatically changing the landscape.

By investing his massive poker earnings in the company and developing this new product, your buyer would now be 11 million dollars “in the hole” on Day 1:

Original Value [-11 million] = Purchase Price [9.1 million] - Development Costs [20.1 million]

After a few decades, however, the company would be worth 79 million:

Business Value [79 million] = Original Value [-11 million] + (Development Gains [3 million/year] x Time [30 years])

By investing his 29.2 million in your company, this buyer would more than double his investment AND own a well-established company capable of even greater innovation and expansion.

Remember – when calculating option-based valuations, remember options don’t last forever. If your company doesn’t quickly exploit this new technology, one of your competitors surely will. In the VR example, you would be wise to counter with a higher offer or hold on to the company and start developing this new product immediately. However, if you have no plans to exploit this new opportunity and seek a more relaxed life of retirement in a VR environment, you may want to take this offer.

Business valuation

Negotiation

Of course, you want to get the highest possible price for your business. However, you and your buyer will probably compromise between your initial high- and low-ball offers. Don’t become discouraged by the numbers – they’re just the beginning!

Convince potential buyer (or yourself, if you plan to hold on to your business for a while) of your company’s full value by highlighting your company’s valuable—but unquantifiable—assets. Ask them how much time and money it would cost them to create a similar business from scratch, including training costs and the value of your experienced staff. Assert the full weight your business’ market presence by highlighting its intangible assets.

Intangibles

You can’t estimate the true value of your company with formulas alone. You must consider the value of your brand reputation, client base, etc. By researching the recent sale prices of other businesses in your niche, you can get a clear picture of your company’s full value.

Compare yourself to other, similar businesses by asking yourself these incisive questions:

  • What does my company offer that others don’t?

  • How do we provide added value to our customers?

  • How do we go above and beyond what they expect from a company in our niche?

  • Have we been in business longer than others?

  • How much trust and goodwill have we built up in our community?

  • What value do our brands/trademarks hold in the marketplace?

And, most importantly:

  • How do customers feel about my company?

By understanding your business’ true value, you can optimize your profits and enjoy a happy retirement – today or decades in the future!

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How Toggl Track can Help

Has your business established a reputation for engagement?

Do your teams engage in paid/unpaid charity efforts?

Does your company participate in community outreach activities?

Have you created research and development value?

Has your company raised awareness of your market sector?

Do you hold any valuable patents/copyrights?

Get a clear, 360-degree perspective of everything your business offers the world and set the best possible price!

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