Doing a business valuation is one of the most important things you can do as an entrepreneur or investor. A business valuation determines what your company is worth, which directly impacts how much money you will earn with it.
Business valuations are very complex, but they don’t have to be! There are many simple ways to do a business appraisal that will give you a good starting point from which to work. In this article, we will go over three easy methods for doing a business valuation.
This article contains links to some free resources where you can get more detail on each method described here. Check them out after you are done! Also, remember that personal values will vary depending on who you ask so make sure to not take these numbers too seriously.
Method #1 - Calculating Return On Invested Capital (ROIC)
In finance, return on invested capital (or ROI for short) is defined as the amount of profit divided by the total cost of owning a company. It assumes that once investment dollars are spent, then profits can be calculated using the same budgeting formula repeatedly. This way, ROI is always being adjusted for changes in expenses.
The standard definition of ROI uses the numerator as net income (profit) minus depreciation and amortization costs. These two terms refer to the yearly expense of selling assets (like computers) and writing off the value of physical products used to run the business (office supplies, etc.).
The first step in doing an efficient business valuation is establishing what the fair market value of your company is. What this means is figuring out how much another company like yours would pay for your company if they were looking to get rid of it or purchase additional pieces of it.
A firm market value can be determined by asking around, researching similar businesses, talking with potential buyers, and calculating price/earnings (P/E) ratios. There are many ways to determine P/Es, but you should use the average, not extremes!
Using averages helps to account for differences in companies that may have different strategies for growth. It also removes personal biases that may influence which numbers people choose to put into the equation.
By using averages, we are assuming that other companies are buying enough to show a profit, thus creating a lower ratio. We then take the opposite side of that and add up all the prices to find our market value.
The next step in doing a business valuation is calculating your company's net asset value (NAV). This is typically done by taking total shareholder equity (TSE) and then deducting off-books liabilities and investments, leaving you with the NAV.
Net asset values are very important when it comes to determining the market or fair value of a company. A high NAVE indicates that investors believe the stock is undervalued; therefore, investing in the stock makes sense. Conversely, if the NAVE is low, then investors do not think the stock is worth as much money so buying it would be wasting their investment capital.
It is very common for entrepreneurs to underestimate how much they own the company due to difficulty distinguishing between personal and professional items. For example, using accounts payable for an office expense instead of employee payroll. Or including equipment that has been gifted to the firm but still count it as an asset!
By having a basic understanding of accounting, this can easily be corrected. Luckily, there are many free resources available via Google and YouTube that can help teach you basics.
The second step in calculating the market value of a business is determining its total liabilities. Liabilities are the money that you owe, either directly or indirectly, due to past debt or legal obligations.
In general, financial institutions will not lend enough capital to purchase an established business unless there are no significant debts or loan payments coming up in the future. Therefore, finding out how much debt your company has left can help determine if it is sellable or not!
By looking at the average cost to buy a similar business as well as what sellers typically get for their businesses, we are able to make an estimate about how much equity (the difference between total assets and total liabilities) your company possesses. This then allows us to come up with a price per share for the stock.
Remember, however, that prices fluctuate so do not invest all of your savings into buying a business! Also remember that selling a business with lots of debt may be difficult since potential buyers will want to know whether or not they will have to pay off these loans before investing in the company.
The second step in doing a business valuation is calculating your company’s equity, also known as its market value. This includes all of the investments you have made in the company (such as equipment or software) as well as the personal property owned by top executives.
It also accounts for any retained earnings- those are the money left over after paying bills and other expenses from the business. Most companies have some form of these saved up, which can be used for future growth or reacquisition. Retained earnings are very important when determining the price that might be paid if you were to sell the company!
Equity is typically calculated using two different methods: the asset approach and the income approach. Both use similar fundamentals and assumptions, so we will go into more detail about each here.
Now, using our business valuation example, let's do some numbers!
First, what is the market price of your company? You can find this information in various online databases or through other sources you've read. For our case study, we'll use the following as our market price: $10 million.
Next, add up all of your company's assets. This will include cash, equipment, furniture, vehicles, etc. It also includes intangible things like patents, trademarks, and copyrights. Make sure to only count tangible items that are directly related to your business.
Once everything has been accounted for, multiply these values by their respective prices to get an overall cost of your company. In our case study, this calculation comes out to be $1,000,000.
Now, divide this number by the market price of your company to determine how much your company is undervalued.
Now that you have determined your firm’s net income, you can multiply this number by its “market" or "assumed" valuation (the price it would sell for in an open auction) to determine how much money you could spend on yourself if you were the owner of your business.
This method is called capitalization and it determines how rich or poor you are as an entrepreneur. The more expensive your business, the wealthier you will make yourself through entrepreneurship!
You should always do at least a simple business valuation before investing significant time and resources into your own company because capitalization isn’t just easy to do, but it also has many variables.
For example, what type of business are you running? If it’s your personal service business then I wouldn’t recommend calculating capitalization due to ethical reasons.
However, if it's a brick-and-mortar store then you need to account for depreciation which is the reduction in asset value caused by use. Depreciation varies depending on how long ago the building was built so check out different formulas online to learn more.
The term asset refers to something that you use for profit or that brings in money, whereas liability means something that costs you money to have. When doing a business valuation, one of the first things is to determine how much your company has an inventory, using that number as a starting point to calculate its value.
Next, you would need to know what it cost to purchase all those items, which are called depreciable assets. Depreciation is when you reduce the value of an asset because you spend time using it or spending money to maintain it. For example, if you own a car, you can deduct the depreciation off of the price of the car when calculating net income.
After taking these two numbers into account, you subtract the latter (liability) from the former (asset).
Now that you have determined your firm’s book value, it is time to do an income-based valuation by multiplying your company’s net profit divided by its average daily revenue (ADR) multiplied by the price per share of stock.
The price per share can be found in several places, such as online investing websites or using the “listing price” at Amazon. You would also need to know how many shares exist for this calculation.
This product will be adjusted down if you don’t use all available cash, since part of the money going into business ownership includes buying equipment and other assets. A good rule of thumb is to assume half of what was spent on the initial investment goes toward the sale of the company.