Determining a business’s value is essential when planning a successful exit. Business advisors, finance professionals, and the business owners themselves use various methods to evaluate assets and ultimately land on a sale price. To help you build a more robust exit strategy and sell your business with confidence, ELLA, a digital workbench for trusted advisors, explains the key elements of valuation and the three techniques to determine it.

What is Business Valuation?

Business valuation, also known as company valuation, is the process of assessing the economic value of a business and its assets. Typically, an advisor will step in during this process to help evaluate the business and determine how to maximize its value based on:

• Assets

• Debt

• Future earning potential

• Market position

• Performance

It's critical for small business owners (SBOs) to work through the valuation process to minimize risk and maximize the value of their business.

Why Go Through A Business Valuation?

There are a myriad of reasons why SBOs want to know the value of their businesses. Often with the help of an advisor, business valuations are commonly completed for:

• Buy/sell agreements

• Estate planning or divorce settlements

• Exit or succession planning

• Securing investment or financing

• Selling or buying a business

• Tax reporting

For many businesses, a yearly valuation (or at least a valuation update) can be critical to a successful exit. For instance, buy/sell agreements often require an annually updated valuation, ensuring a fair price for both all parties.

Likewise, if an owner plans to sell within one to five years, it's essential to track how their initiatives improve the business's value over time. Keeping an annual valuation schedule can attract investors as they can spotlight steady growth in the company.

But it's useful internally, too. During an after-valuation, owners can benchmark their business's performance against market trends and set smarter goals.

How to Value a Business?

There are simple approaches to valuing a business, such as book value (detailed below), where one subtracts liabilities from assets. However, this myopic method misses much of a company’s value. It’s precisely for this reason that other valuation methods exist, such as the income-based and market-based approaches.

There are different reasons why an advisor or business owner would want to use one method over the other. That said, two methods stand out among the rest as being more advantageous and accurate, especially for most small privately-owned businesses (<500 employees). With a good understanding of what a valuation is, why an SBO would want one, and how they’re calculated, let’s look closer at each method.

Book Value - Asset-Based Approach (Not Recommended)

Book value is a helpful approach to use for business owners trying to get a rough estimate of their company’s value. Using information from its balance sheet, you can subtract the company’s liabilities from its tangible assets (e.g., cash, investments, inventory, property, machinery, etc.) to determine owners’ equity. The figure remaining represents the value of the tangible assets the company owns.

Basic Formula: Book Value = Total Assets - Total Liabilities

The value derived from this formula should be used only as a rough estimate. Most business advisors will agree that relying on this basic accounting equation will provide an inaccurate representation of a business’s actual value.

Discounted Cash Flows (DCF) - Income Approach

The benefit of using the discounted cash flows (DCF) method is that it highlights a business’s ability to generate liquid assets (e.g., cash and cash equivalents) and helps buyers see long-term earning potential. It’s based on the free cash flow (FCF) a business is expected to generate in the future.

Basic Formula: DCF = Present value of discounted cash flows + discounted terminal value

The accuracy of DCF relies on the terminal value of the business and the number of years being forecasted. Terminal value is the total value of all future cash flows beyond the forecast period. The forecast is simply how many years out you’re forecasting growth. Most advisors use three to five years.

Advisors use two primary methods to calculate terminal value: the perpetuity growth method and the exit multiple method.

Perpetuity Growth Method (a.k.a. Gordon Growth Model)

The perpetual growth method assumes that a business will generate cash flows at a constant rate forever. Using this method helps estimate the value of all those future years of free cash flow (FCF).

Basic Formula: Terminal Value = next year’s FCF ÷ discount rate – the growth rate

Discounting is necessary because of the time value of money (TMV). TMV contends that money is worth more now than at a future date based on its earning potential, as money can grow when invested. TMV creates a discrepancy between the current and future values of a given sum of money.

Exit Multiple Method

Instead of assuming a business will operate forever as the perpetuity growth method does, the exit multiple method assumes the business owner will sell at a specific time, often at the end of a forecast period. This forecast period is usually three to five years, although a few industries require a longer time horizon (e.g., startups, natural resource companies, pharmaceuticals, etc).

Using the exit multiple method, an advisor will choose a financial metric from the final forecast year, such as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), revenue, or net income. They’ll then use a “multiple” based on what similar companies sold for. For example, if most manufacturers in the same industry sell for five times their EBITDA, that would serve as the multiple.

Basic Formula: Terminal Value = Final Year Metric × Exit Multiple

By and large, business professionals prefer the exit multiple approach, whereas academics favor the perpetual growth model.

Comparable Company Analysis - Market Approach

Using comparables, or “comps”, is another valuation method mainly based on what similar businesses have sold for. Advisors make these calculations based on:

• Comparable Sales: Use data from similar recent business sales

• Rule of Thumb Multiples: Apply a multiple to a financial metric (e.g., Seller’s Discretionary Earnings (SDE) or EBITDA) based on appropriate industry multiples.

Basic Formula: Value = SDE × Industry Multiple

As an alternative to EBITDA, seller’s discretionary earnings (SDE) measures a business’s true earning power for a single owner-operator. SDE starts with net income and adds back:

• Any discretionary spending not essential to operations

• Depreciation and amortization

• Interest and taxes

• One-time or non-operating expenses

• Owner’s salary and perks

SDE is generally better for owner-operated small businesses such as restaurants, retail shops, and service providers (i.e., the buyer will replace the current owner). Conversely, EBITDA is better for businesses with full management teams that aren’t owner-dependent and is the industry standard for mergers and acquisitions.

By understanding these valuation methods and their applications, small business owners and advisors can confidently navigate the complexities of business valuation. Whether preparing for a sale, attracting investors, or planning for the future, leveraging the right approach ensures that all stakeholders achieve the best possible outcome.