Introduction to valuing a business

Valuing a business can be daunting, especially if you do not have a background in finance. Small business owners must value their company to make informed decisions about its future.

This post will walk you through the three primary ways to value a small business.

Firstly, we will explain these methods in plain language so you don’t get bogged down in technical jargon. In addition, this post will guide you through valuing your business and provide a simple formula for calculating its worth. Finally, we will give you a rule of thumb for valuing a business, so you know what to expect.

Nevertheless, you will better understand the business valuation process. We will equip you with the tools to make informed decisions about your company’s future.

Summarily, if you are a small business owner looking to take the next step, keep reading.

Three ways of valuing a business.

This section will explore the three primary company valuation methods. A guide for small business owners in navigating the valuation process.

Asset-Based Approach

This calculates the value of a company’s assets minus its liabilities. Use for businesses with significant property, equipment, and inventory assets.

Moreover, if you own a small business with a considerable asset base, this method may be the most appropriate way to value your company.

Income-Based Approach

The method calculates the value of a company based on its expected future income. Use for businesses with a history of stable earnings and positive cash flow.

Furthermore, this method can estimate your company’s value if your business generates steady profits.

Market-Based Approach

The third method is the market-based approach, which looks at the prices of comparable recently sold companies. Use this method for businesses in a highly competitive industry.

To get a more accurate estimate of your company’s value, consider all three methods when valuing your business.

The formula for valuing a company.

Valuing a small business can be a complex process, but with the right formula, owners can determine the worth of their company.

The formula for valuing a company combines elements of the three approaches. These consider the company’s future earnings potential and the market value of similar companies.

Here is the formula for valuing a company:

Company Value = (Net Profit x Multiple) + (Asset Value – Liability Value)

“Net Profit” is the company’s annual net profit. “Multiple” is the industry-specific multiple used to value similar companies. Meanwhile, “Asset Value” and “Liability Value” refer to the total value of the company’s assets and liabilities.

Furthermore, income statements and balance sheets are necessary to determine these values accurately. These statements provide a quick overview of the company’s financial health and performance. They are critical in calculating the net profit and asset and liability values.

Let us use a coffee shop scenario to show applying the formula. Suppose a coffee shop generates an annual net profit of $100,000. The industry-specific multiple for coffee shops is 2.5. Furthermore, the coffee shop has $50,000 in assets and $20,000 in liabilities. Here’s how to calculate the value of the business:

Company Value = ($100,000 x 2.5) + ($50,000 – $20,000)

= $250,000 + $30,000

Company Value = $280,000

In conclusion, this formula allows small business owners to understand their company’s worth. This knowledge helps owners make informed decisions about their company’s financial health.

Steps in valuing a business.

To value a small business, thoroughly analyse financial data, industry trends, and other factors. Below are the steps small business owners can take to value their businesses:

Firstly, research and analyse business information, including financial statements, industry trends, and market conditions. This step helps owners grasp their business’s performance and position in the market.

In addition, adjust the financial statements to reflect the business’s true value.  Make adjustments, such as removing non-op expenses or adding growth expenses, to refine the valuation.  This step ensures that financial statements reflect the business’s financial health and performance.

Furthermore, after the adjustments, small business owners should choose the appropriate valuation method. The choice of method will depend on the nature of the business, the industry, and the purpose of the valuation. The three main methods are the asset-based, income-based, and market-based approaches.

Once you select the valuation method, apply it to the adjusted financial statements. This involves calculating the values of various variables. This includes net income, earnings before interest and taxes (EBIT), or price-to-earnings (P/E) ratio. This step provides small business owners a comprehensive understanding of their business’s worth.

Finally, small business owners can conclude value after applying the valuation method. This involves weighing the results of the valuation against other factors. This includes the business’s strategic goals, market conditions, and potential buyers or investors. This step gives small business owners a realistic and informed value estimate.

By following these steps, owners can determine business worth. This helps them make informed financial decisions for the future.

Rule of thumb for valuing a business

In addition to the three main valuation methods, small business owners can use a rule of thumb to estimate their business’s value. A rule of thumb is a general guideline or heuristic commonly used in a particular industry to estimate the value of a business.

One example of a rule of thumb is the “multiple of earnings” approach. This involves multiplying the business’s annual earnings by a particular factor, such as two or three, to estimate its value. Retail, restaurant and service businesses commonly use this approach.

However, it is important to note that a rule of thumb is not a precise valuation method and should only be a rough estimate. The estimate’s accuracy will depend on various factors. This includes the industry, market conditions, and the business’s specific characteristics.

Sometimes, a rule of thumb may not be appropriate or applicable.  Businesses with intellectual property or unique assets may need a specialised valuation approach.

Despite its limitations, a rule of thumb can still give small business owners a helpful estimate of their business’s value.  Small business owners can use a rule of thumb to estimate business value quickly and identify improvement areas.

The rule of thumb is not precise but useful for small business owners in certain industries to estimate their value. However, they must understand the limits.

Conclusion

Small business owners must value their business to make informed decisions about a company’s future.  Understanding your business’s value can improve investment, M&A, and retirement planning decisions.

It’s important to note that valuing a business can be complex, considering many factors.  Seek help from a financial expert for accurate and reliable valuations.

At myCFOng, we specialise in providing virtual finance and accounting services to SMEs and startups. Our team can help you navigate valuing your business. Please contact us today to learn how we can help you value your business.