Business Valuation 101: How, why, and what we do to value your business

I know, I know – it is July, and you are not ready to go back to school yet 😊 Get out your pencils as today we are covering a foundational element of the business sale process – valuing a business.    

In previous posts we have described early considerations when thinking about selling your business, 9 steps to take when you are ready to sell, and what to expect when selling your business. 

This post will go into detail on the 3 approaches used in valuing a business, valuation considerations, and the process that we use as seasoned business brokers, CPAs, and valuation professionals.

Business owners need valuations and market comparables for a variety of reasons beyond selling their business, including for strategic planning and forecasting, buying out or bringing in a partner, to review eligibility for a commercial loan, private wealth & estate planning, divorce, etc.

We do a consistent volume of valuation preparation, advisory, and review for business owners. In fact, this is a great way for a business owner to “test out” a Business Broker. If you are interested in our valuation services, we do provide these as either a flat fee depending on the industry, complexity, and size of the business and/or bill on an hourly rate to provide input and considerations on a valuation that has already been prepared (examples here include partner disputes and divorce).

There are three primary valuation approaches: market, income (discounted cash flow or DCF), and asset (sometimes called cost, book, or liquidation value).

Depending on the facts and circumstances of a particular business, applying the three approaches independently of one another can yield conclusions that are substantially different. A valuation professional will seek to better understand your business and help you assess the pros / cons of these approaches as they relate to your business.

Our firm is a member of Axial, a premier M&A / transaction platform. They have a good overview of these valuation approaches. I will paraphrase here:

Market approach

Similar to pricing / valuing real estate, this approach pulls in business transaction comparables and analyzes multiples of revenue, gross profit, EBITDA, discretionary earnings, and other financial metrics. Accuracy here depends on incorporating enough comparison transactions that are applicable to the business being assessed.

Asset approach

Based on the assumption that a conservative / prudent buyer would pay no more than the value at which the business assets could be replaced or reproduced. This approach is rarely used for well-performing businesses, as the earnings that those businesses generate should support a higher valuation than the book value of the underlying assets. When I walk through these approaches with business owners I describe this approach as being applicable to a distressed restaurant.

Income approach

Often referred to as a discounted cash flow (DCF) analysis, this approach converts anticipated economic benefits into a business value. The most academic of the approaches, a DCF model takes the future cash flow streams (along with a terminal value) of a business and discounts them back to the present using their weighted average cost of capital. This model is highly dependent on a handful of assumptions, like the projected cash flows, terminal value, and discount rate, and may have a limited or little connection to real-world market valuations.

In addition to these approaches, Axial calls out several qualitative factors:

  • Size: All other factors being equal, bigger businesses are seen as more diverse, and therefore safer, and thus command higher valuation multiples
  • Industry: The size and perceived health of the target’s industry is also an important factor. Even rock stars in out-of-favor industries will see lower valuations than when their industry outlook is more favorable
  • Growth: Businesses that have a track record of higher growth are more valuable, as long as that growth is believed to be sustainable into the future
  • Management: Companies do not run themselves, and so those with exceptional management at the helm receive higher valuations than those with lackluster management teams

The valuation process is iterative

After reviewing financial statements (Profit & Loss and Balance Sheet) and IRS filings we work with you to get questions answered about the financials and better understand the operating model and any unique aspects (products, markets, customers, suppliers, value prop, etc.) of the business. For context, consider a couple examples of business owners we have worked with:

  • 3 upscale gyms in metro Seattle. Greater than half of revenue came from personal trainers bringing customers to the gyms and offering individual or group classes. Valuation considerations: What would the impact of these trainers moving to a competitor gym be? Are employment / non-compete agreements in place for trainers? Could monthly dues / subscription / contract revenue be increased? What is the duration of the facility leases – is rent expected to increase?

  • $11M+ boutique, event marketing firm. This business has grown consistently and is highly profitable – the owner enjoys an enviable lifestyle. There was one piece of the business that would raise red flags with prospective buyers, 60% of revenue was from a single tech company. Valuation considerations: Is there a contract in place with the tech company? Is the relationship with the tech company dependent upon personal relationships that the business owner has? How does the business profit and growth record look when this customer is excluded from the financials?  

  • Suppose I told you that two HVAC firms had identical revenue and profits last year. However, the first firm averaged 8% growth for the past 4 years. The second firm lost a contract with Spokane schools and actually saw a small decrease in revenues since 2018. Valuation considerations: mix of residential vs commercial work, service vs install / equipment revenue, recurring customer %, and geographic coverage of each business (is one business in a growing, affluent area relative to the other?).

I imagine you are starting to appreciate the nuance and context involved. When business owners contact us they frequently ask about a multiple for their industry. The considerations called out in the Axial article and the examples above are some of the reasons why we do not quote multiples over the phone during an initial consultation – it is not advised without better context about your business, the operating model, and customer base.

The valuation assessment process involves:

  1. Analyzing financial documents, tax filings, and supplemental information
  2. Recasting Income Statements and Balance Sheet items as appropriate for non-operating, non-recurring expenses to arrive at the true economic ownership benefit
  3. Analyzing industry and transaction comparables for appropriateness
  4. Calculating a value range
  5. Reviewing other, unique considerations such as inventory, real estate, working capital requirements, and (if applicable) a calculation of loan support to arrive at financing capacity

We have talked about reviewing financial statements and tax returns; however, it is critical to identify non-recurring expenses and add-backs that will need to be accounted for to arrive at a true understanding of the cash flows of a private business.

An example here would be a large piece of equipment you purchased and expensed in 2021 to take advantage of favorable depreciation / tax treatment. Suppose a machine cost $250k and was estimated to last for 10 years, that said, the expense was realized entirely this year. This is a defensible adjustment to the P&L and an example of an “add back” or “recasted” item. Depreciation and interest expense are two frequently recasted items, as a new owner of your business would have a different capital structure.

So how and where do we access market comparables from?

In addition to being a licensed CPA and member of the Washington Society of CPAs, we are active members of the International Business Broker Association; through these affiliations we have access to a number of valuation tools and transaction comparables.

We also subscribe to DealStats, the gold standard used by deal experts, business brokers, CPAs, and transaction attorneys in valuing private businesses. It contains comparables on 35,000+ businesses. In addition, we have access to BizComps, another valuation tool with comparables on 14,000+ businesses. Beyond these we have access to 500+ industry guides and rules of thumb through the Business Reference Guide and a network of seasoned business brokers that have represented and sold thousands of businesses over 40+ years.

Want to read more on valuation approaches? Here is an additional resource we recommend:

https://www.bizbuysell.com/learning-center/article/6-rules-of-thumb-for-business-valuation/

Hopefully we have shed some light on valuation methodologies, the assessment process, and transaction databases / comparables.

That is it for today – more to come in a future post. Please forward or share this content if you find it valuable. As always, thank you for reading! 

At Washington Business Brokers we are experts in valuation, optimizing a business for sale, buyer identification and qualification, negotiation, deal structuring, and closing. Our strategic advisor, Glen Cooper, has sold 500+ businesses in his career and is a nationally recognized author and trainer in selling private businesses.

We do not sell you on selling your business or buying one. Instead, we listen, provide options and expertise, and ultimately partner with you to accomplish your goals.

If you would like to better understand the value of your business or learn more about the process of confidentially selling:

call or text 937.344.8750
email [email protected]
or schedule time for an exploratory, free chat here

1 thought on “Business Valuation 101: How, why, and what we do to value your business”

  1. Pingback: Business Valuation 401 – Thinking about Your Business from a Buyer’s Perspective - Washington Business Brokers - Sell a Business - Confidentiality, Transaction Expertise, Results - Serving Seattle, Bellevue, Tacoma, Everett, Bellingham, Spokane, Vanco

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