Business owners or potential investors have several methods for calculating the value of a business. The assets are classified differently depending on whether a company is being liquidated, used as loan collateral or purchased for continued operations. Understanding the different methods for valuing a business will help you determine the most accurate value of the company.
Determine the Reason for the Valuation
The first step in determining the value of the business is to look at why you need a number. If you’re liquidating a business, you might be looking to pay off debts and walk away from the company. On the other hand, you might want to get as much profit as you can from the closure. In this case, you won’t need to calculate the value of potential future earnings. If you are selling the business to someone who wants to continue operating it, future earnings potential is important in calculating the value of the company. So is the value of intangible assets such as the business’ reputation, known as goodwill. Or, you might be using the business as collateral for a loan. In this case you’ll probably need more than the loan value as collateral because lenders will want to be able to quickly sell your assets if you default on the loan, and this usually requires selling assets at a discount.
Create a Balance Sheet
Write a list of the business’ assets and liabilities to get is current net worth. Start with tangible assets such as equipment, inventory, cash, receivables, investments, patents, trademarks, recipes, royalties and other components of the business you can quickly sell. Next, write a list of the business’ liabilities, which include any debts you owe or contracts you must fulfill. If you can walk away from a contract but have an early termination fee, list the fee as a liability. Finally, list the company’s intangible assets such as goodwill, grandfathered zoning or code exceptions. If you can’t easily place a value on assets or sell them quickly, you can include them as intangible assets. These can include patents, trademarks, recipes, logos, a website URL and the company’s name.
Subtract the liabilities from the assets to get the company’s net worth. If you are looking for a quick sale and don’t care about getting anything for intangible assets, leave them off the balance sheet. Do not include future earnings on a balance sheet.
A complete business valuation includes an earnings projection. This is the probable profit the company will earn during the next three to five years. In a simple valuation, you can use previous earnings, such as those from the last three years. If you are selling the business or making a case for a loan, you might need to justify your projected earnings by using additional research, data, statistics and other information to support your claims. For example, a restaurant might use population-increase trends to show that the business will have a larger potential customer base in the coming years. A daycare center can use single-family home sales projections or census data in a geographic area as an indicator of potential new customers.
Decide on an Earnings Multiplier
Once you know the business’ projected earnings, stakeholders will need to decide how to use them to value the business. This often includes multiplying the earnings by a number of years. For example, if the business makes a profit of $250,000 annually, a seller might want four times earnings for the business, or $1 million. The buyer has to decide if he can do better than $250,000 in annual profits or generate those profits for more than four years. Multipliers differ for different business types, according to a July 2010 article in The New York Times. For example, the article Determining Your Company’s Value: Multiples and Rules of Thumb, citing data from Business Brokerage Press, says the multiplier for retail auto parts is 40 percent of annual sales plus inventory.
Sam Ashe-Edmunds has been writing and lecturing for decades. He has worked in the corporate and nonprofit arenas as a C-Suite executive, serving on several nonprofit boards. He is an internationally traveled sport science writer and lecturer. He has been published in print publications such as Entrepreneur, Tennis, SI for Kids, Chicago Tribune, Sacramento Bee, and on websites such Smart-Healthy-Living.net, SmartyCents and Youthletic. Edmunds has a bachelor's degree in journalism.