How To Value a Small Business in 3 Simple Ways

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Entire textbooks have been written on business valuation, and our intention is not to bore you with all the details. Instead, we’d like to provide a comprehensive guide on how to value a small business and give you actionable and practical steps to get the right answer.

These are the three most common ways to determine the value of a business:

  1. Calculate the value of assets.
  2. A technique called discounted cash flow (DCF).
  3. Look at similar companies and estimate what they’re selling for. 

Let’s take a look at all three in more detail. 

How to Value a Small Business: Assets 

The most basic way to value a business is to figure out what the hard assets are worth and subtract any debt the business owners have on the business. Imagine a landscaping company with trucks and gardening equipment. These hard assets have value, which can be calculated by estimating the resale value of the equipment minus any debt. 

This valuation method often renders the lowest value for the company because it assumes a business does not have any goodwill. In accountant speak, goodwill has nothing to do with how much people like a company; goodwill is defined as the difference between a company’s market value (what someone is willing to pay for it) and the fair market value of net assets (assets minus liabilities). 

Typically, companies have at least some goodwill, so in most cases you’ll see a higher valuation by using one of the other two methods described below. 

How to Value a Small Business: Discounted Cash Flow (DCF)

In this method, the acquirer is estimating what future stream of cash flow is worth to them today. They start by trying to figure out how much profit is expected to be made in the next few years. The more stable and predictable cash flow is, the more years of future cash they will consider. 

Once the buyer has an estimate of how much profit is likely to be made in the foreseeable future, and what the business will be worth when they project selling it, the buyer will apply a “discount rate” that accounts for the time value of money. The discount rate is determined by the acquirer’s cost of capital and how risky they perceive a business to be. 

Rather than getting hung up on the math behind the DCF valuation technique, it’s better to understand the drivers you can control when an acquirer uses this method. These are determined by answers to the following questions: 

  1. How consistent have profits been, and for how long? 
  2. How much profit is expected to be made in the future? 
  3. How reliable are those estimates? 

How to Value a Small Business: Comparables 

Another way to determine the value of a business is by looking at the value of similar companies that have recently sold or whose value is more or less public knowledge.

For example, accounting firms typically trade at one times gross recurring fees. Home and office security companies trade at about two to three times monitoring revenue; most security company owners know the comparables technique because they often get approached by private equity firms rolling up small security firms. You can usually find out what companies in an industry are selling for by asking around at an annual industry conference. 

The problem with using the comparables methodology is that it often leads owners to make an apples-to-bananas comparison. You may compare a business with a similar company in the industry that just sold, but without an intimate understanding of their business, you may be drawing a comparison that isn’t there. Private companies are just that—private. That means you can estimate things like their profit, gross margin, and growth rate, but unless you have insider knowledge, you will just be guessing. 

To avoid guessing, owners often look for public comparables information, which leads to comparing themselves to a large publicly traded company in the same industry—and that is a recipe for regret. 

For example, because medical technology companies generally trade for 20 times last year’s earnings on the New York Stock Exchange (NYSE), a small medical device manufacturer might think they too are worth 20 times last year’s profit. However, we can tell you, after analyzing tens of thousands of businesses that use The Value Builder System™, a small medical device manufacturer is likely to trade at a fraction of 20 times. Small companies are deeply discounted when compared with their large, publicly traded counterparts, so measuring a company’s value against a Fortune 500 giant will often lead to disappointment.

If you’re asking yourself how to value a business, use all three techniques and compare the range of results. The value of a business is likely to fall somewhere in that range.

What’s the Business Worth to the Owner?

The worst part about selling a business is that you don’t get to decide which methodology the acquirer chooses. An acquirer will do the math behind closed doors on what the business is worth to them

They may decide a business is strategic, in which case you should back up the Brinks truck because there’s about to be a handsome reward for the company. But in most cases, an acquirer will use one of the three techniques described here to come up with an offer to buy the company. 

Perhaps a tougher question to answer is what’s the business worth to the owner? One of the most common mistakes owners make in valuing a business is estimating how much money they need to retire and then using that figure to determine their selling price. The two numbers have nothing to do with one another. Just because they calculate they need $1 million to retire doesn’t mean the business is worth that to an acquirer. By starting with your retirement nut, they’re answering a different question—about the value of the business in no one’s eyes but theirs.

What a business is worth to the owner may have little bearing on its market value, but it can be the biggest determinant as to whether they sell. There are practical and philosophical ways to answer this question. 

Practically, they probably generate an income and enjoy some benefits from owning a business, and you can calculate the cost of replacing that stream of cash. This kind of math can help determine what the business is worth to the owner, but will have no bearing on what it is worth to someone else. You need both numbers—and if you stick with us for a moment, you’ll see why. 

Philosophically, what the business is worth to the owner is a much trickier question. There are many intangible benefits to owning a business; these are hard to quantify. For example, what’s it worth to be recognized as an important member in the community when walking down Main Street on a Saturday morning? What’s it worth to see a job well done, knowing they made it possible? How to value the feeling of pride from employing someone who might have trouble finding a job elsewhere? 

Similarly, owning a business involves a number of intangible costs that may drag down its value. For example, what does it cost emotionally to worry about a business every day? What’s the psychological toll of having to let someone go? What’s the cost of the stress endured knowing most of your net worth is tied up in a business? What’s the price of having to check your mobile phone while on vacation?

Weigh these intangible benefits and costs, and do your best to calculate what the business is worth to the owner

Knowing When to Sell

Now that you’ve learned the basics of how to value a small business, the next important step is knowing when to sell. Start by comparing the two numbers: what the company is worth to the outside world and what it’s worth to the owner. When the value of the business to an outsider exceeds what it’s worth to them personally at this point in their life, then it may be time to sell. 

Likewise, if a company is worth more to the owner than it would be worth to a buyer, putting it on the market now will be an exercise in frustration. 

Value the business using all three approaches to get a rough sense of what the company could be worth to a buyer. Then do the math and the soul searching with the owner to figure out what the company is worth to the owner. If it is worth more to a buyer than it is to the owner, now may be a good time to sell.

Conclusion

To summarize, let’s revisit the essential steps in how to value a small business. First, determine business value by exploring the assets, utilize the DCF technique, and compare the business against similar companies and their sale prices. Evaluate the wide range of results and somewhere in the middle, you’ll likely find a ballpark number that serves as the value of the business.

If you’ve started to ponder questions like, ‘how to value a small business,’ or ‘how to determine the value of a business’, you’re likely thinking about selling the company. If so, use the simple exercise we introduced to quickly diagnose the business value and assess the owner’s readiness to exit.  

How To Improve the Value of a Business

After determining the value of the business to an outsider and what it’s worth to thw owner at this stage of their life, you may decide not to sell and focus instead on building the value of the company. 

Here at The Value Builder System™, we’ve studied tens of thousands of businesses and the offers they get. We have discovered there are eight unique factors that drive the value of a business.

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A value assessment toolset that helps advisors start more strategic conversations with business owners.