How do you estimate the economic value of your business? Whether you have been in business for 20 years or are just starting a business, at some point you’ll encounter the need to put a monetary value on your business. However, business valuation can be difficult and complicated if you aren’t a financial expert or don’t have an experienced financial team.
We’ll explore why you need to value your business and show you how to use a straightforward, four-step business valuation method.
Know what your small business is worth.
There are many reasons why you need to value your business, including the following:
– The business is for sale.
– You’re trying to find investors.
– You’re planning to sell stock in your business.
– You need a bank loan for your business.
– You need to fully understand the growth of your business.
The most common reasons for valuing your business are for investment and sales purposes. Valuing your business means you can tell an investor, a shareholder, a buyer, or a banker that the business is worth X; so if you want Y percent of it, you need to pay Z.
A business valuation is critical for presenting to investors and buyers. Proving the value of your business is critical to getting their attention. If you can’t show an investor how much your business is worth, how will they know how much money to invest?
Methods to calculate the value of your business
There are a number of ways to determine the value of your business. The multiples method and the discounted cash flow (DCF) method are the two most commonly used.
1. Multiples method
The multiples method assumes that similar businesses are selling at similar prices. In this method, you need another company in your industry that has recently sold. Take the selling price and divide it by that company’s total revenue, EBIT (earnings before interest and taxes), or EBITDA (earnings before interest, taxes, depreciation, and amortization). You’ll get a number; this is the multiplier. Then multiply the multiplier by your company’s revenue, EBIT or EBITDA to get a valuation.
2. DCF method
The DCF method doesn’t take into account the results of other companies. It focuses on your company’s projected cash flow instead. You provide your best cash flow forecast for the next three to five years. You then use a formula to calculate the present value of those cash flows.
Present value is a concept that compares the amount of money earned in the future to the amount the investor would have received in interest if they had kept their money. It uses a discount rate, which is the likely interest rate the investor could have earned if they had saved the money. If the present value of your business is higher than the amount invested, it’s a good investment.
With a projected cash flow of three years, the formula is:
Value = Cash Flow Year 1 + Cash Flow Year 2 + Cash Flow Year 3 (1+ discount rate) (1+ discount rate)2 (1+ discount rate)3