How to Calculate your Business Value
It's a common question we ask ourselves as business owners, but it's often hard to pin down the answer as the value of your business can vary based on many factors.
In this article, I'll go through a simple way of calculating the value of your business.
This method is based on understanding how most potential buyers of your business will evaluate the value of your business and what they are willing to pay.
Calculating the value of a business is a relatively straightforward exercise when you understand what drives business valuations.
Valuing a business is all about the return the purchaser will get on their investment (the purchased company).
Think about your personal investments. When evaluating which investment to pursue, you usually consider:
1 - What return you will receive on your invested funds (i.e. 5% annual return).
2 - What Risk is associated with the investment (i.e. there is a 90% chance you will receive a 5% return – that's a low-risk investment).
Business valuations are done on the same basis, evaluating the return and the risk.
To determine the value of your business, you have to calculate the return a purchaser is likely to receive on their investment. From here, the risk involved in your business will increase or decrease the purchase price.
The return a purchaser will want is driven by other returns they could get if they invested their money somewhere else. For example, here are some typical returns for investors:
8% – Average annual stock market returns (a moderate risk investment).
1% – Average cash interest rate, if you are lucky (a low-risk investment).
Typically, business purchasers will want a higher return than they could get from a moderate risk investment like the stock market. They will often want a 15-40% Return.
A formula to calculate your business value
Here is a simple example to give you 'an idea' of what your business is worth – of course, it is only worth what someone is willing to pay for it.
1. Calculate the return the purchaser will receive on their investment.
A typical business valuation method will use the profit of your business to calculate the purchase price. When calculating the valuation of a company, since you want to know the potential purchase price, you work backwards using the company's profit and a desired rate of return.
Note that the rate of return refers to how quickly the purchaser gets their investment back from the profit of the business.
Here's an example.
The valuation of a small business with an average annual profit of $300,000 with a 20% desired rate of return would result in a $1,500,000 purchase price.
The purchase price is calculated by dividing $300,000 by 20% ($300,000 / 20% = $1,500,000).
With a purchase price of $1,500,000 the purchaser would receive a 20% return if the business continued to produce an annual profit of $300,000 ($1,500,000 x 20% = $300,000).
And the Purchaser would have a 5 year payback on their investment ($300,000 x 5 = $1,500,000).
Your company's profit and the purchaser's desired rate of return are two factors that impact commercial valuations.
2. Determine the risk associated with your business.
Identifying how risky it would be to invest in your business is a more challenging exercise since it is subjective.
The importance of determining the risk is that it impacts the return a reasonable investor will use to calculate your company valuation.
Remember, a low-risk investment lowers the return an investor expects.
If your business is considered a low-risk investment, the desired return may be as low as 15%. With a 15% Return and $300,000 in annual profit, the profit-based business valuation formula results in a purchase price of $2,000,000.
Contrast that with a high-risk investment, the desired return may be as high as 40%.
With a 40% return and $300,000 in annual profit, the business valuation model results in a purchase price of $750,000.
That is a significant difference in the business valuation – $2,000,000 vs $750,000 – a 166% increase in the value of your business, based on your company being considered low risk.
This profit-based valuation is a simple example to help you answer the question ''what is my business worth?''.
Other Factors impacting your business value
Business valuations are often complicated by many other factors, including taxation, property or equipment owned by the business, patents, intellectual property, revenue growth, profit growth, the industry outlook, economic growth forecasts, synergies between the purchasing company and acquired company, key senior employees, company debt, pending litigation, etc.
These factors make business valuation consulting a necessity for large business transactions.
Factors impacting profit
Since profit is a significant factor in small business valuations, business valuators will use a ''normalised'' profit when calculating the purchase price. They normalise profit by making adjustments to profit by considering items, such as:
Historical profit – is the average profit over the past 3 to 10 years. Typically the purchaser will pick the number of years resulting in the lowest historical profit, attempting to lower the business evaluation.
Profit trend – is the trend of the profit increasing or decreasing? If the trend is decreasing, the purchaser will forecast continued decreasing profit, resulting in a lower purchase price proposal.
Significant anomalies – if there was a significant one time sale resulting in a larger profit in a year, purchasers will often discount the gain for that year on the assumption that including that sale is not 'normal' business.
Owner expenses – when valuing a business for sale, the seller will want to remove all personal costs flowing through their business, increasing profit. The rationale is that personal expenses do not impact the company's performance.
Minimising business expenses and maximising profit in the years leading up to selling your business can significantly impact valuing a small business.
Factors impacting risk and return
Since risk directly impacts the return a purchaser seeks from their investment, a business owner wants to do everything within their power to reduce the risk associated with their company.
Here are some ways to reduce risk in your business.
Build processes – businesses that operate with clearly defined processes highly reduce the risk of something going wrong. One of the best examples of great processes is McDonald's. They have multi-million dollar locations often run by teenagers because they have clearly defined processes.
Business owner(s) not involved in the day to day operations – think about this. A purchaser would love to buy a business and have the employees run the business without the owner being involved and still earn a 20% return on their money.
Great employees – finding and keeping great employees is one of the most challenging tasks in any business. Demonstrating that you already have great employees who run the business effectively will lower the risk of your business and increase your small business valuation.
Many customers – a risk in any business is losing customers. Suppose a company is built on having a small number of million-dollar customers. In that case, the risk of losing a customer can significantly impact the business. Suppose a business has a lot of small customers. In that case, the risk of losing one customer is much lower because if one is lost, they are easier to replace.
Recurring or subscription-based revenue - sales is a crucial driver impacting profit. Having a business model that automatically invoices customers on a recurring or subscription basis reduces the risk associated with sales. When a purchaser looks at evaluating a business, determining the likelihood of sales continuing will directly impact their valuation.
Reducing the risk associated with your company will positively impact the valuation of a small business. Could you start thinking about ways to do it for yourself?
In summary - How to calculate the value of your business
Remember the keys to maximising the value of your business are:
1. Increasing profit regularly and sustainably.
2. Reducing risk in your business.
Improving both aspects of profit and risk will positively impact your business valuation.
If you would like to discuss your business's value, why don't you consider our virtual CFO service?
Tailored specifically for small business owners, we can help improve the core financial functions in your business, helping you increase profits.
Above all, you'll gain a trusted financial expert in your business to make sure your business is always on the right track.