2/23/2017

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Determining Value
The value of a business is determined by the price a seller and a willing buyer can agree on.
by John M. Roberts

Determining the value takes into account several means of valuation such as cash flow, asset valuation, the capitalization of income, business performance, market valuation, and multipliers.

When people start businesses, buy businesses, or inherits a business, they often put values on them that are based on emotions and unrealistic expectations.  Their perception of value is based on sentiment rather than on what the market actually dictates.  This is great, but one day they may have to come to grips with the fact that sentiment does not equate to monetary value.   

Some people treat their business with kid gloves while nursing and caring for it like it is a child.  Whether the business is making a ton of money or just barely breaking even, they put a lot of hard work into it.  They grow to love the business, equate their love with value, and then expect others to share their feelings. They become emotionally attached and believe that the business is worth a fortune simply because it is their baby. 

In reality it may not be worth nearly that much as they think it is.  But to them, it is worth every dime until they are shocked into reality when they try to sell it.  Like anything else that is bought and sold, the business will have to be appraised.  It won’t matter whether it is sold on the open market, privately, or through other channels, and you can be sure that your personal feelings won’t add one dollar of value to the sales price.

The value of a business is calculated in ways similar to that of real estate and other tangible properties.  This means that if the business is eventually sold, more than likely, it will be valued according to industry standards and figuring out the value will be of the utmost importance. 

There are 6 basic methods used in determining the value of a business.   

(1)  Cash flow:  The flow of money coming into a business can take on different connotations.  The cash flow can be negative, positive, or break even.  It is the incoming and outgoing cash that is most crucial to any business and it is one of the determining factors for anyone who is contemplating buying an established business.

(2)  Asset valuation:  Although asset evaluation is used primarily in retail and manufacturing industries, it is also an important way to help appraise small businesses.  Banks and other lending institutions often calculate the value of assets such as equipment and inventory when determining whether a business can qualify for a loan. 

(3)  Capitalization of income:  The return on investment is important whenever there is a sale of a business.  The capitalization of income focuses on many important aspects of the business such as trends in the marketplace, the work force, current and future sales, how long the company has been in business, how it has operated, and most importantly, the earnings and cash flow.  It helps determine how long it would take the new owner or an investor to recoup their initial investment.

(4)  Performance:  How a business is performing on a day to day basis is critical in evaluating its worth.  Even if a business generates high income, the amount of money that goes out may be considerably more and neutralize any positive gains.

(5)  Market valuation:  The market influences the value of businesses by making comparisons of similar companies that have sold in the recent past.  Market evaluations are similar to those used in real estate appraisals.   By examining the similarities of businesses that have recently sold, a reasonable sales price can be established.

(6)  Numeric Formula:  The value of a business is often determined by using a numeric formula.  This is seen at times on the hit television show, Shark Tank. A value is determined by the businesses ability to generate a particular amount of cash flow within a one year period which is then multiplied by a standard rate, usually between 2 and 3 percent.  The multiplier includes debt service, a living wage for the owner, and Rate of Investment (ROI) which are the profits made after capital investments are calculated.

You should always have a realistic idea of what your business is worth whether you are thinking about selling it or not.  No matter how much knowledge you have about your business, you may not know the ends and outs of selling a business, therefore, it may be a good idea to enlist the help of professionals who are skilled at selling businesses.

 

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