If you plan to sell your business or you’re considering buying an existing one, the first thing you need to do is learn how to value a business. The valuation process will not only let you know the price of the company, but you’ll also understand how the company and its industry operate.
In addition, the results from the valuation can give you clues to increase the revenues or reduce the expenses.
How to value a business based on its assets
With this appraisal method, a monetary value is assigned to the company based on the difference between its assets and its liabilities. A list of all the assets of the company is made, and each item is assigned a monetary value. Both tangible and intangible assets are accounted for:
- Tangible assets. They are all physical assets that can be assigned a fixed price. These include real estate, accounts receivable, inventory, machinery, equipment, and cash in hand.
- Intangible assets. These are non-physical goods that have a certain value for the operation of the business. Among them are trademarks and patents.
- Liabilities. The liabilities of a business are its debts and other obligations that the company must pay in the future.
This form of appraisal is very useful for companies with a large number of assets or investments; companies whose capacity to generate income in the long term is limited, or businesses about to be liquidated.
This type of valuation is also used in the case of companies that operate as sole proprietorships or LLCs, since they do not have shares that can be transferred or put for sale, and only their assets can be sold.
Likewise, this mechanism serves internally to keep track of the expenses and capital of a company.
Basic concepts to learn how to value a business
Choosing a method when deciding how to value a business is the first step before putting a price tag on it. Of course, to estimate the value you must take into account the financial status of the company, its industry, and its performance.
But, in addition, there are other elements that come into play. Knowing them can ease the appraisal process. However, if you feel you need help, ask for the advice of an accountant or a commercial broker. These professionals can guide you on how to sell a business and how to price it accurately.
Some key elements that you should know are:
Discretionary Vendor Income (SDE)
When calculating the SDE, you’ll have a better idea about the true profit potential of a company. To make this valuation, all the expenses listed in the tax return, which are not necessary to manage the business, are added to the sum of the assets. This method is used especially in small companies with a single owner.
To calculate the SDE of a business, pre-tax and interest earnings are taken into account. You also have to account for any purchase that is not related to the company’s operations, such as vehicles or trips, but that is included in the business expense report.
Likewise, it is necessary to include donations, business trips, purchases that are not paid with cash, and expenses that are made only once and will not recur in the future.
To calculate the SDE, you must also take into account various factors that depend directly on the business. In contrast, to assess the multiple of the SDE of a company, you must consider the industry standards to which it belongs.
There is a different SDE multiple for each industry sector, which may also vary for each business. This will depend on the volatility of the market, the geographical location of the business, the size of the company, the assets, and the risk that may exist when transferring the company to another owner.
If the company depends largely on its owner to operate, it will be difficult to transfer its ownership, and its value will decrease. If the business is going to be sold to a different industry sector with high expectations of growth, the SDE multiple will be higher and, therefore, the value of the company will increase.
With a business plan, you can project the profits of a company and the growth of the market. If you plan to sell your business, this document will serve to show potential buyers what your strategies are for making the company continue to grow and earn revenue over time.
In addition, it offers potential buyers a broader picture of how your company works, talks about its mission and the services or products it offers. Likewise, if you plan to buy a business, this is the kind of information you need to know in order to make a well-informed decision.
For those who are interested in buying your business, it is important to know how they will reach customers and generate revenue. The business model explains how to achieve it; through direct sales in stores, consulting services, an online store, etc.
On the other hand, if you are the one looking to buy a company, the business model should illustrate how the company operates and account for its assets and liabilities. In other words, it should be a guide for you to make a decision based on a detailed analysis of the entire business and its financial statements.
A formula you can use to value a business
There is a formula you can use to value a business. To better understand how to value a business, you need to know all the elements that make it up. The formula is expressed as follows:
Estimated value of the business =
(SDE) x (Multiple SDE) + (Real Estate) + (Accounts Receivable) + (Cash) + (Assets that are not part of the SDE or the Multiple SDE) – (Business Liabilities)
It’s a simple formula but it can help you determine how to value a business. To obtain the real value of the company, you have to multiply the Seller’s Discretionary Income or SDE, by the SDE multiple.
Then, you have to add the assets of the business to the result. These assets refer to properties, accounts receivable, money in cash, and any other asset that is not included in the SDE nor in its multiple.
Finally, all liabilities must be subtracted: accounts payable, pending expenses, taxes payable, and any significant liabilities. By doing this simple math you’ll get the real value of the business you want to price.
Learn everything you can about the industry
Whether you want to sell or seek to buy a company, and if you want to know how to value a business, you must also know in depth its industry sector.
If you are thinking about selling, understanding how the sector your company belongs to will help you value it better since you’ll be comparing all its attributes with those of similar companies. For this reason, you should find out as much as you can about similar companies in size, with a similar business model and comparable profits.
If you are buying, find out what are the market trends that can affect the business of your interest. This will allow you to determine precisely the amount you should offer, according to what others would be willing to pay for it.
But the truth is that, whether you are buying or selling a company, knowing its real value is not the only reason why you should learn how to value a business.
In fact, the valuation process in itself can increase the value of the company and help its managers make better-informed decisions. With all the data collected they can know the company’s strengths and weaknesses, and how to act accordingly.
A measure to increase the value of your business is applying for a business loan. You can invest the loan funds in specific areas of your business and thus increase production, sales, and profits in general. To start this process, simply fill out this form to know instantly if you qualify for a Camino Financial business loan. Soon after we will contact you to guide you through the rest of the process.