Every small business owner should conduct an annual valuation process, to form a baseline and learn about the variables that determine its changing worth. This exercise is particularly valuable when your business is up for sale or you are trying to attract new investors, and you may also need it when applying for certain types of funding. In these instances, demonstrable evidence of your business’ value is necessary.
There are several methods of valuation that can be applied to small businesses. Two of the most commonly used are the multiples and discounted cash flow methods. Since the multiples method is easier, let’s get started with a simple 6-step process.
- Add up the value of your tangible and intangible assets: Assets are anything your business owns including property, equipment, machinery, inventory, and other items of value. Calculate their value using cost minus depreciation. Intangible assets are things you can’t necessarily see and touch, such as your growing database of customers or your name recognition and the positive attributes people associate with your brand. These things would have no value outside of the context of your business.
- Subtract debts and liabilities: Debts and liabilities are anything your business owes, including accounts payable for bills from vendors, notes payable for promises of payment, and other forms of money owed, including unfulfilled contracts or subscriptions.
- Determine your business revenue: Calculate your business’ annual sales. Then research to find out the valuation of companies in your industry and local area and their sales. If businesses like yours are typically valued at a certain ratio of earnings to sales, such as 3X, apply that formula to your revenues to determine your valuation based on revenue.
- Apply earnings multiples: Project your earnings going forward for three years. Look at the price-to-earnings ratios of public companies in your industry and determine an average. If the typical P/E ratio is 5 and your projected earnings are $150,000 a year, then your business would be worth $750,000 using earnings multiples. This method is ideal for businesses with an established track record of annual earnings.
- Look at cash flow: Using a discounted cash flow analysis. This income-based approach to valuation is based on the idea that the value of a business is equal to the present value of its projected future benefits. Based on expected future cash flows, what would your business be worth today?
- Consider other impactful variables that would strengthen your business’ value: Whereas the above approaches are based on financial formulas, there are subjective factors to consider that may raise your valuation above number crunching results alone. These may include potential strategic value for a business seeking to acquire your business capabilities or customers, desirable geographic location, or the momentum your business has gained in recent years.
However you decide to incorporate these steps into your process, make sure that you remove emotion from the equation. You may choose to do that by hiring a consultant to conduct the evaluation process for you, or guide you through it. This will keep you from inserting natural owners’ biases into the process.
If you would like to learn more about Cactus Cash and what we can do to help your business’ growth prospects, call us at (832) 892-0723.