How is a Business Valuation Calculation Performed?
Professionals recommend performing a business valuation for a multitude of reasons. Business valuations serve to guide business owners through selling the company and making exit plans. However, business owners should also consider a formal business valuation calculation for tax purposes and estate planning. These calculations vary dramatically depending on the life stage, profitability, and expected growth of the company.
Each business valuation is unique, so there isn’t one simple calculation that will work for every company. A business valuation is necessary to assess and better understand the value of a business. Online calculators are not enough. These calculators are simple and quickly produce somewhat realistic figures. This valuation approach is incomplete because these calculators don’t account for elements not found on financial documents. Strength in the industry risks in the market, and growth or profit opportunity can redefine the company’s worth.
To perform a comprehensive business valuation, an expert will evaluate financial documents and objectively review its performance, products, and customers.
Financial Documents Necessary for a Business Valuation Calculation
These core financial documents establish the foundation of every business valuation. This first step gives a paper value that buyers, investors, or estate planners can use as a starting point.
This section of formal documentation includes:
- Open Contracts – especially long-term contracts
- Business Plans
- Exit Strategy
Initially, the deeds, licenses, and certifications will serve to establish or confirm the company’s ability to continue business as usual. Open contracts, patents, and the business plan provide some insight into the future of the company. An exit strategy is the proof that there are plans to ease the process of the business changing hands.
Proprietary documents are almost always private, and it’s the company’s record of all their intellectual property. Additional confidential, proprietary information that could impact the company’s value include salary structure, customer lists, and even marketing plans.
Financial statements include the business’ cash flow statements, income statements, and balance sheets. For a complete business valuation, a company should produce the last three years’ financial statements. The only exception is when the business has not been open for that long.
The balance sheet puts the assets and liabilities side-by-side. A bookkeeper should prepare this regularly, with at least one formal balance sheet annually. However, the income statement looks at the revenue after all the expenses accounting for the cost of goods sold and the operating costs.
These are the documents that investors rely on because it creates a clear image of its financial position.
Tax Filings and Returns
During any business valuation calculation, the tax filings and returns showcase the cash basis earnings and potential investment. When buyers purchase a business, especially a small business, paying taxes on earnings is an investment.
Including these tax documents also surveys how much the tax documents and internal documents tie together. Depreciation, amortization, and some interest payments aren’t reflected in month-to-month internal documents, whereas they would appear in tax documents.
A business valuation agent will conduct a thorough SWOT analysis. A SWOT analysis weighs the company’s strengths, weaknesses, opportunities, and threats. The SWOT analysis is a critical piece of the valuation puzzle because it evaluates the company with the industry and market in mind. It also gauges internal performance. It’s possible that the company may be working on a new product that holds great potential and minimizes threats.
Often business owners will conduct a SWOT analysis when seeking investors. However, this process is also critical when valuing a business for estate planning or looking to sell the business.
It’s vital that a third-party conduct this analysis as a business owner or operator may have a bias when assessing strengths and intentionally downplay weaknesses. A SWOT analysis should present data, facts, and a realistic look at the organization.
Different Business Valuation Calculations
Depending on the business, the industry, and many other factors, there are a variety of different valuation methods. These are calculations that evaluate various elements of the business’ assets, the opportunity for growth, and position in the market.
The Simplest Business Valuation Calculation — The SDE or Seller’s Discretionary Earnings
The Seller’s Discretionary Earnings, or SDE, represent how much the money the owner makes from the business. The owner could represent a single person, a set of partners, or more persons who own, control, and profit from the company. Calculating the SDE is relatively straightforward.
(Net earnings (before taxes) + personal draw (or owner’s draw) + non-essential expenses) – all liabilities = SDE
In a few steps calculating the SDE looks like:
- Start with the business’ year-end net earnings before taxes.
- Add the owner’s payment.
- Add all non-essential expenses – Anything that does not fall into COGS or recurring costs.
- Subtract all liabilities such as unsettled bills and debts.
- The result of steps one through four produces the SDE.
The most common question regarding the SDE calculation falls onto step three. What expenses are critical, and which are non-essential? Rent, insurance, utilities, and COGS are all essential. However, equipment upgrades, travel expenses, events for staff, and participation in conventions are not essential.
Completing the SDE Calculation with an Industry Multiplier
The SDE calculation would not be complete without applying an SDE Multiple or the industry multiplier. This number will bring the SDE figure and recalibrate it to produce the fair market value of the company.
The multiplier depends on:
- Trends in the market
- Size of the business
- Company assets (intellectual property and tangible assets)
- Additional variables such as branding, marketing success, and company reputation
The SDE multiple factors in elements that the SDE calculation didn’t account for initially. Companies access the SDE multiplier through consultants, professional valuation services, or appraisers. Some business owners choose to use multipliers found in business reference guides, which require that the owner purchase the guide to hopefully find the right multiplier for the company.
Calculations for Up and Coming Businesses
Up and coming or inherently profitable businesses need a unique twist on business valuation calculations. They need a way to show the scale of their growth and profit potential while also addressing the risks or threats that could impact the business.
To do this, businesses that have a consistent growth rate, or a fair amount of opportunity, should use the discounted cash flow calculation. Typically the discounted cash flow will determine a value-based a scaled-back version of the business’ cash flow. By discounting a portion of the value, the calculation should accurately represent the potential of future losses.
The Discounted Cash Flow Calculation
The discounted cash flow calculation is complex. It’s so complex that Microsoft Excel has two prewritten formulas to calculate the DCF.
To calculate the DCF independently, follow these steps:
- Determine the discount rate. In the formula, this will stand as “r,” the rate may be a percentage or the weighted average cost of capital.
- Determine the time intervals – calculation below uses years.
- Determine ‘N’ as the total time.
- Follow the calculation
(Cash flow for year 1 / (1+r)1) + (Cash flow for year 2 / (1+r)2) + (Cash flow for year N / (1+r)N) + (Cash flow for last year / 1+r)
The excel formulas rely on a series, where the user inputs the data, and then the program runs a calculation. It is only as reliable as the data and the user inputting the information.
How Risk Impacts the DCF Valuation
A discounted cash flow analysis must undergo a risk adjustment. That’s the purpose of this type of valuation. The discounted rate represents the loss or discount in value, and often the weighted average cost of capital (WACC)stands as this rate. This is the ‘r’ of the formula above.
The DCF valuation typically, but not always, uses the average weighted cost of capital to determine the cost of acquiring or financing the business. The benefit of this valuation method is that it presents both the hopeful silver lining and the realistic risk associated with the business.
Advanced Calculations for Established or Successful Businesses
When a company has more advanced assets, hopeful growth projections, or a stable history of increased growth, it may call for more advanced calculations. Those calculations will rely on forecasts, detailed financial history, including financial management strategies, and present value.
To conduct a capitalization of earnings style valuation, the business must present financial reports and tax returns. Then the professional working with the company would determine specific forecasts for risk and profit.
The formula is:
Net Present Value / Capitalization Rate
The only disadvantage of using this method of valuation is that the projections may be off the mark. On occasion, projects are inaccurate. Then there is the chance for the extraordinary and unexpected, but those fall into the potential buyer’s risk tolerance. Typically, companies using a capitalization of earnings valuation leave the risk on potential buyers.
A Business Valuation Calculation Goes Beyond Formulas
Every business valuation is unique, and the idea of a one-size-fits-all approach is impossible. Some companies pitch that they produce instant valuations based on advanced calculators, but those calculators can’t include all elements of risk and possible reward.
A fair and complete business valuation relies on a foundation of quantitative or objective financial information and fact-based information relating to risk and growth. Then a professional should hand the subjective information taking into account various opinions and perceptions. A business valuation calculation must give careful but deserving weight to the strengths and the weaknesses of the company.
For business valuations that evaluate the whole of the company, contact American Fortune, where top analysts and advisors handle individualized valuations.