How to Calculate The Value of a Business For Sale
Are you a business owner who’s preparing your business for sale? If so, then you’ll most likely need to prove to the buyer that the selling price is fair. Justifying to a potential buyer why the sale price is what it is can help your credibility and ensure a faster sale. If you’re interested in knowing how to calculate the value of a business with intentions of selling, this article will expand your knowledge on business valuations.
Below are three most frequently used approaches when developing a realistic valuation that can be used to justify your sale price.
Income Approach – Earnings Multiple Method
There are several methodologies that could be applicable to a determined case within the income approach. The capitalization of income and discounted cash flows methods are the most common when valuing a business.
EBIT X Multiple
When using the earnings multiple method, you must calculate a measure of adjusted earnings. Most frequently used is EBIT (earnings before interest and tax), which is then adjusted to obtain a measure of “normalized EBIT”, accounting for things such as non-regular expenses and transactions not at market value. The value of the business is then obtained by using the adjusted EBIT number and multiplying it by an applicable variable.
The applicable variable, or multiple, is a representation of the associated risk. Therefore, the lower the risk, the higher the multiple.
Discounted Cash Flow (DCF)
This method focuses on the future performance of your business rather than historical records. Through a DCF method, an estimate of the cash flows of your business is projected and then discounted back into current dollars (or net present value). The rate at which the cash flows are discounted accounts for the time value of money and the level of risk indicated by your business or industry. For example, a medical device manufacturing business is usually considered a higher risk than a grocery store.
The discount rates can be understood as the inverse of the multiples in a capitalization of income method. The higher the risk, the higher the discount rate.
Cost Approach – Asset Valuation Method
Total Assets – Total Liabilities = Net Asset Value
Assets are resources that have economic value. The assets that a business owns include things such as cash, receivables, or plant and equipment. On the other hand, liabilities are obligations such as bank loans or accounts payable. In order to find out the value of your business under a cost approach, there are several steps:
- adjust all assets and liabilities to their market value
- find the sum of all your assets
- find the sum of all your liabilities
- deduct total liabilities from total assets
This number, known as net asset value, is the value of the business.
Market Value Approach
When calculating the value of a business for sale, analyzing recent transactions taking place in the market can provide valuable insight. These transactions could occur in liquid and frequently traded markets (stock market) or in less liquid private markets. Nonetheless, as the time since the last transaction increases, the information becomes less important, especially after substantial changes taking place in their industries. It is very important to find businesses that are very similar across several factors in order for it to be a worthy market comparable. This means finding similar businesses and considering things such as industry, size, location, and other factors specific to the target business.