Not only do owners and executives of privately-held businesses often wonder about the worth of their enterprises, they also have lots of other questions, too—like what they can do to improve the value of their business.
Determining the value of a business can be broken down into four common methodologies for systematically deriving worth. Let's have a look at each.
1. Book Value
The simplest, and usually least accurate, of the valuation methods is book value. This focuses entirely on the balance sheet and the book value of assets minus any relevant liabilities. While there are many flaws to this approach, it is still commonly employed by valuation experts, although it is usually given a very small weight relative to the other methods. For our example, let’s assume your company’s book value comes to $2,000,000.
2. Publicly-Traded Comparables
The public stock markets assess valuation to every company’s shares being traded. This provides a basis for determining the value of your company, particularly when compared to companies similar to yours. This method usually looks at the last twelve months (commonly referred to as LTM) and next twelve months (NTM) of revenue and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA):
A valuation expert would input your company’s performance and projected performance next to the average multiples in each category and come up with an estimated value in each category. Then, the expert would determine a weighted average for the four different estimates and arrive at a valuation of between $8 and $10.8 million for this method. We’ll use $9.5 million for our example.
3. Transaction Comparables
The next approach for valuation follows a process similar to the publicly-traded comparable example above, only the focus is on recent transactions. By looking at the multiples of LTM and NTM revenue and EBITDA for recent transactions and applying those multiples to your business, you would arrive at the estimated value based on this method. Let’s assume we derive a value of $8.5 million for our example.
4. Discounted Cash Flow
While the first three methods described focus mostly or entirely on historical performance, the discounted cash flow method is almost solely-driven by the projected performance of the firm into the long-term. This method derives the cash flow the company will produce into perpetuity, if applicable, and then discounts those cash flows back into today’s dollars (also referred to as net present value (NPV)). Let’s assume this method finds an estimated value of $11 million.
Cash flow is the single greatest determinant in the value of your business. It's also simple to grasp: How much cash have you generated and how much will you generate in the future? The more consistent and predictable your cash flows are in your business model, the higher the value of your business.
With four different estimated values, a weight is applied to each to come up with the overall estimated value.
The lowest weight was assigned to the book value method (because it is the least representative, in almost all cases, of the true value of a firm) with equal weights going to the remaining three. This is not always how it works, but this is not too far from how things are currently being done by valuation experts as long as there is credible information available for each method.
Once the weighted valuation is derived, there may be some other discounting factors. Since the securities of privately-held businesses do not have a liquid and active market in which to trade, a discount is often applied to the valuation to account for this, minority interest positions, and other factors.
Several additional subjective elements can affect business valuation, but those are worthy of an article of their own. Nevertheless, with these general guidelines, you should be able to come up with an "envelope calculation" of the value of your business. For anything more serious, you should consult a valuation expert who can apply these and other relevant principles to the valuation of your business in much finer detail.