Valuating a Business

The number one question business owners ask themselves when considering selling their business is for how much can they sell their business.  We have to keep in mind that business valuation is more of an art than a science; even though we have several valuation methods, the sales price is the minimum amount the seller is willing receive and the maximum amount the buyer wants to pay.

There are several valuation methodologies including the income, market, and asset based approach.  The most popular approach is the income based approach, which attempts to calculate the present value of future cash flows.  This can be done through the Discounted Cash Flows method (DCC), but it is more practical for small businesses to use the multiples approach. Here are the steps to value a business using the multiple approach:

1. Forecast Free Cash Flow (Owner's Benefit)
Most business brokers calculate free cash flow, also known as the owner's benefit, based on last year's actuals. In reality, it should be a forecast of the cash flow which typically is the cash flow 5 years from today. The point is to use a yearly cash flow that best represents the actual cash flow the business will generate annually. Note: it is more common for mid-size and larger businesses to use EBITDA instead of Free Cash Flow.

2. Calculate Free Cash Flow or EBITDA Industry Multiple
The first step is to get a list of similar businesses sold last year in the same industry; "similar" in terms of sales, assets, number of employees, or any other category used to find comparable businesses.  It is important that the businesses pertain to a common industry because multiples vary across industries. Next,  divide sales by Free Cash Flow or EBITDA for each business to calculate the multiple. For example, if a particular business sold for $1 Million and its Free Cash Flow during the year it was sold was $200K, the multiple is 5.  Calculate the multiple for all businesses and then obtain an average multiple.

3. Calculate Continuation Enterprise Value
To calculate the business value, we then multiply the FreeCash Flow or EBITDA times the average industry multiple we calculated in step 2.  For example, if five years henceforth Free Cash Flow results to be $100K, the continuation value would be $500K ($100*5).  In conclusion, the value of the business $500K, which should approximate the present value of future cash flows by using the DCC  method.  This is because in the long run, businesses in the same industry have similar growth rates, profitability, and risk and consequently, the multiple approach is a reliable estimate.

When working with a real estate or business broker, it is important for business owners to understand the basics of business valuation.  Some business brokers will not take a listing, unless the business is sold for no more than a two times the annual cash flow multiple.  The reality is that during the last few years, small businesses generating less than three million dollars in annual sales sold at an average of two times yearly cash flow.  However, it does not mean that a business can't sell at a higher multiple, in fact, businesses often sell for much more, but it mainly depends on the industry and type of buyer.  For instance, strategic buyers are willing to pay more than the average for a particular business.  To learn more about small business valuation, I recommend to read the Business Reference Guide by Tom West.  This guide is used by business brokers as a starting point to value small businesses.