We are frequently asked by business owners and their advisors if there is a quick formula to determine what a business is worth. In reality, the valuation of a business is a complex undertaking and the market ultimately determines value. Although strategic buyers will often pay a premium price for a business, our experience has shown that there are three key components that are used in computing valuation models: 1) earning power; 2) value of the assets being sold; and 3) marketplace demand.
Earning power is a function of annual earnings. For larger businesses, particularly those with audited financial statements, an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) calculation is used. For smaller businesses, the calculation is adjusted by adding back the expenses attributable to private ownership. (At FBB, we use the term “Adjusted Profit” to describe that concept.) An appropriate capitalization rate is then applied to calculate value. Most investors place extensive weight on the company’s ability to generate earnings, since the cash flow allows them to: 1) pay themselves a suitable salary; 2) pay off the debt generally required to buy the business; and 3) receive a return on investment. The appraised or fair market value of the assets being transferred is also considered. These factors are overlaid on industry and market conditions to come up with a range of value for the business. Due to the complexity of the process, we typically place little value on industry rules of thumb.
(originally published in the July 2011 eNewsletter)