When you own a small business, it’s easy to get caught up in the day-to-day. Inventory, payroll, customer service, managing employees—you’re working 10, 12+ hour days to keep the business running smoothly.
Sometimes that means the business’s big picture sits on the back burner, at least until it becomes urgent. When the time comes to search for a bank loan, bring on an investor, or prepare to sell your business, that big picture becomes very important.
Knowing the true value of your business gives you a better foundation to start conversations and plan for your future. That’s why we’re reviewing the three most common valuation methods and what every business owner needs to know about them.
The Benefit of Understanding Your Company’s Value
There are so many reasons why it’s helpful to know the value of your business.
Some common scenarios include:
- Future tax planning (profits, losses, and projections)
- Securing a loan to grow or scale your business
- Evaluating insurance coverage
And if you’re like most business owners, most of your retirement income will rely heavily on the sale of your business. Knowing what that number looks like helps you create a more realistic retirement plan.
There are many ways to determine the value of your business. In fact, you may find it helpful to calculate the average of a few different methods. But if you are using any of these values to determine the majority of your retirement income, we recommend working with a retirement planning professional.
The Book Value: Your Business’s Net Worth
The book value is a reasonably simple valuation type, but it’s not comprehensive.
Capital assets – liabilities = your business’s net worth
Capital assets include tangible things like your building, equipment, inventory, supplies, patents, etc. Liabilities primarily refer to any debts your business may have, like a mortgage on the building, business loans, credit, and other debt.
While simple, this valuation doesn’t consider critical elements that make your business stand out.
A rather considerable asset this strategy misses includes intangible assets such as brand name, reputation, or customer loyalty, all of which are the backbone of a prosperous small business.
In addition, this method does not account for company profits. When calculating your personal net worth, your salary isn’t part of the equation. The same idea applies to your business. The company’s profits aren’t included in the net worth analysis.
Because profit alone isn’t a descriptive marker of your company’s financial position. For example, you could have a lot of assets, like your building, but modest profits. Or, you could have few assets, like if you rent your office space and don’t own inventory but make sizeable profits.
Knowing your company’s book value is a great place to start, but other valuation strategies may clarify how much it’s worth.
The Enterprise Value: The Multiplier Method
Now we’re moving into a valuation that’s a bit more technical. The basic formula for the enterprise value is:
EBITDA x multiplier = value
What Does EBITDA Stand for?
EBITDA means Earnings Before Interest, Taxes, Depreciation, and Amortization. Essentially, the EBITDA looks at your company’s cash flow (typically over the last 12 months). When using this valuation method, you may need to adjust the EBITDA amount to account for owner expenses, including a higher than average salary, bonus, or personal expenses.
Finding The Multiplier
Okay, now that you have this acronym down, how do you figure out the multiplier?
The multiplier is made up of several factors, including:
- Revenue or business size
- Revenue trends (growth, stagnant, or decline)
- Recurring revenue
- Competitive edge (patents or other intellectual property)
In general, the smaller the multiplier, the smaller the valuation. Keep in mind that this method does not consider debt. To get an accurate projected business sale price, you must factor any debts into the equation.
While it’s a more comprehensive approach, this method is also complex and more subjective. If you’re planning on using this approach, it’s best to have a business valuation expert help out, so you know you’re working with accurate numbers.
The Market Value Method
When you sell your house, the realtor, mortgage lender, and appraiser look at comparisons in your area to determine its value. That’s the general idea of the market value method—you’re comparing your company’s value to similar companies that have recently sold.
When pursuing this method, be sure to compare apples to apples. For example, a general dentist practice will likely have a different sales price than an oral surgery office, even though they both fall into the umbrella of dentistry.
If you use this method, look for companies of similar size, revenue, debt, industry, location, specialization, and more. This is a suitable method for getting a ballpark figure, but it doesn’t provide the level of customization that the enterprise value or book value does.
Valuation Is Critical For Retirement Planning
There’s no one “right” way to attain your business’s actual market value. You may even find that using several of these standard valuation methods helps you better understand where you stand.
While many business owners think they know the value of their business, the reality is that they probably don’t. Using one of these popular valuation methods removes the guesswork of putting a number on your business.
This number helps inform your next steps as a business owner looking toward the future. If you’re eventually planning on selling your business, and the profits are potentially higher than you thought, you may decide to retire a little early. If you anticipate lower profits, you may consider working a few extra years.
A business valuation is an effective tool you can use to start building your retirement plan with confidence and clarity.
Craig Toberman is a Partner at Toberman Becker Wealth – a fee-only, fiduciary financial advisor based in St. Louis. He assists families and businesses with strategic financial planning and long-term wealth management. He has over a decade of experience in financial services and has crafted custom financial plans for hundreds of families and businesses.