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valuation

How do you value a business? The methods and formulas explained

An accurate business valuation is a crucial step for both sellers and buyers of any business. In this article, we walk you through the most common valuation methods and formulas.

Whether you’re thinking about selling or buying a business, the most important thing you’ll need is an accurate business valuation.

An accurate valuation will ensure you can set the right asking price and sell your business at its true value, giving you the tools you need at the negotiation table. For buyers, it can help you understand the true value of your potential investment. So how do you go about doing it?

While there are a few different methods and the formulas can get complicated, we’re here to help break through the jargon and get you started. Our free valuation tool ValueRight can simplify the process, making it easy to understand and complete.


How to value a business

There are three main methods for business valuation, which use different metrics for assessing how much a business is worth. Let’s take a further look:

Seller’s Discretionary Earnings (SDE)

This is a method for business valuation which starts with net income, and then adds back the salary taken by the owner, as well as any other discretionary expenses (expenses that are non-essential to the operation of the business). When calculating SDE, you also add back depreciation and amortization costs, which measure the value of business assets over time.

SDE aims to provide a complete picture of a business’ financial situation by accounting for all the expenses and cash flows associated with it. Many businesses, particularly small and medium-sized ones, are valued at a multiple of their SDE depending on the industry they sit within. SDE is also the method which BusinessesForSale’s ValueRight tool uses.

What kind of business is SDE valuation best suited for?

SDE valuation is generally best suited for small and medium sized business, especially in transactions where a new owner/operator is taking over from an existing one.

What is the formula for SDE valuation?

Seller Discretionary Earnings (SDE) = Pre-Tax Income (EBT) + Owner’s Salary + D&A + Discretionary Expenses + Non-Recurring Items


Discounted Cashflow (DCF)

This method for business valuation looks at projected future cashflows. DCF takes a company’s projected cashflow over a period of time (usually every year for the next five to ten years) and then subtracts the weighted average cost of capital (WACC). A company’s WACC is the average percentage of its income it will have to pay back to shareholders and investors as debt or equity. This figure will be higher for companies with high amounts of debt or volatile stock.

DCF tries to take into account the ‘time value’ of money – the idea that £10 today is worth more than £10 in the future because it can be invested. It can be used to gauge the future value of a business as well as it’s current value. However, one disadvantage of the DCF model for valuation is its reliance on projected figures for future earnings, which might differ in reality.

What kind of business is DCF valuation best suited for?

Discounted Cashflow (DCF) valuation is best suited to businesses that have access to accurate future projected earnings, or an interest in measuring future value as well as current value.

What is the formula for DCF valuation?

Discounted Cashflow (DCF) = [CF/(1+R)^1] + [CF/(1+R)^2] + … [CF/(1+R)^n]

Where:

CF is the cash flow for the given period

R is the discount rate (the WACC)

And N is the period number (ie year one, two, three etc)

business valuation


EBITDA Multiple (earnings before interest, taxes, depreciation and amortization)

This valuation method takes a company’s net income, and then adds back the amount that was subtracted for interest, taxes, debt and amortization to find its EBITDA. A multiplier – which changes depending on the industry – is then applied to the company’s most recent EBITDA.

EBITDA aims to demonstrate the underlying profitability of a company before expenses, and regardless of its financial choices. However, some argue that it overstates profitability by not taking these costs into account.

What kind of business is EBITDA valuation best suited for? Companies or industries that are asset-intensive, where a lot of value is contained within equipment.

What is the formula for EBITDA Multiple valuation?

Enterprise Value / EBITDA

Where:

Enterprise Value = Market Capitalization + Total Debt - Cash and Cash Equivalents

And EBITDA = Net Income + Taxes + Interest Expense + Depreciation + Amortization


How can I use these formulas to value my business?

If you have all the necessary financial information, you can use these formulas to calculate your business’ value for yourself. However, you might want to recruit the help of an experienced accountant or business broker who can accurately value your business.

Another option is to make use of an online valuation tool, such as BusinessesForSale.com’s ValueRight. If you want a quick snapshot of your business’ value, you can use ValueRight Express to do so with just a few pieces of information and five minutes of your time.

To get started, all you’ll need is:

  • Your profit and loss statement
  • Owner salary and benefit information (all shareholders)
  • Financial statements for the last 3 years (1 year minimum)

You can also use the full ValueRight tool for more detailed analysis into the true value of your venture.



Stuart Wood

About the author

Stuart is Editorial Manager at BusinessesForSale.com. He has worked as Editor for a B2B publisher, Content Manager for a PR firm, and most recently as a Copywriter for Barclays.