The Art and Science Behind Small Business Valuation

It’s often said that there is both art and science behind small business valuation, but what does that mean? It can come across as an excuse to keep the process opaque and mysterious. But in fact, the opposite is true: A good business valuation is all about clarity. 

To get that clarity, business appraisers rely on a number of tools in their valuation toolbox. Some of those tools are based on what’s visible, while others are part of the “secret sauce” that comes from an appraiser’s experience and judgment.

In this article, we’ll start by reviewing the science that goes into performing a business valuation. We’ll look at why it’s not always a straightforward financial analysis, and uncover some of the art that comes into play. This article will also offer a few tips on how to make sure you get a valuation report that is useful, insightful, and well worth the cost and effort.

Who this article is for: This article is written primarily for small business owners in the lower middle market (sales $2M to $25M) who want to estimate selling price before talking to a potential buyer. There are many ways to determine a business’s value, all of them depending on who wants to know the value and why.

The Science Behind Business Valuation

There are three main approaches to valuing a business: income, asset, and market. Each one entails the use of financial formulas and data inputs. Here’s a brief overview of the three approaches, including when they are the most useful:

The Income Approach

The income approach finds the present value of the future earnings associated with a business. In other words, it’s a forward-looking valuation approach. The primary methods used with the income approach are ​​the Capitalization of Earnings method and the Discounted Earnings or Discounted Cash Flow method (DCF).

The science behind the income approach has two parts. The first is determining the anticipated future cash flows of the business. This is done using both company and industry growth projections.

The second step in the income approach is determining the capitalization rate or discount rate. There are a number of widely-used industry resources that help the valuation analyst come up with a reasonable discount rate. In essence, the discount rate needs to encompass both the time value of money and the risk associated with the type of business being valued.

When Is the Income Approach Useful?

The income approach is particularly useful for companies with the following characteristics:

  • A profitable company expecting cash flow to fluctuate in the coming years
  • A profitable company expecting growth to fluctuate in the coming years
  • Companies anticipating high capital expenditures in the next few years
  • Companies that have reliable forecasts for projected earnings

The Market Approach

The market approach values a business based on its earnings, and how the business compares to similar businesses that have recently sold.

The science behind the market approach involves a straightforward, two-part equation: Earnings x Multiplier. 

The first step is to find an appropriate earnings metric for the business — for example, SDE (seller’s discretionary earnings), net income, or EBITDA (earnings before interest, taxes, depreciation, and amortization). EBITDA adjustments may or may not be made by the valuation specialist, with the goal being to show the true cash flow from operations of the business.

The next step in the process is to find appropriate valuation multiples for the business. The multiple, or range of multiples, can be found by researching comparable business sales.

Information about the sale of privately-held companies is not public (for obvious reasons). However, valuation analysts subscribe to several databases that collect information from bankers and business brokers when deals are closed. This information is used to determine a reasonable multiple given the size, industry, and other characteristics of the business.

When Is the Market Approach Useful?

The market approach is often used in the following scenarios:

  • To determine an asking price for a business for sale
  • To decide whether or not it is a good time to sell a business
  • To uncover the primary value drivers/detractors in a business
  • To guide internal planning and decision making, short- and long-term

The Asset Approach

The asset approach finds the value of a business by subtracting its liabilities from its assets. There are two methods used to find the asset value of a business: Book Value and Adjusted Net Asset Value. The science behind either method is fairly straightforward.

Book Value simply uses the values for business assets and liabilities as they appear on the current balance sheet. The danger here is that Book Value doesn’t account for the fact that the assets may have been depreciated down to zero, yet still have useful life and value to a buyer.

Adjusted Net Asset Value takes all assets — this includes tangible assets like real estate, machinery, equipment, etc., and intangible assets like the customer base and Goodwill — and adjusts them from Book Value to Fair Market Value (FMV). Then all recorded and unrecorded liabilities are subtracted.

When Is the Asset Approach Useful?

The asset approach is useful in the following scenarios:

  • Liquidation
  • Companies operating at a loss
  • Businesses no longer going concerns
  • Companies that hold investments or real estate

Some people mistakenly assume that all businesses are worth their Net Asset Value. They liken business valuation to the common method bankers use to get your statement of net worth: To find “worth” you simply take the value of assets and subtract liabilities. 

What asset value ignores is that a successful and historically profitable small business is usually worth more by valuing its earnings. 

If a business is a going concern and its assets are worth more than its cash flows it could be an indicator that something is wrong. Valuation analysts often use asset value to represent the lowest possible value for a business.

The Art Behind Business Valuation

Small business valuation: person playing a saxophone

If you take an informal survey you’ll find that most experts think business valuation is more art than science.

The art behind business valuation comes down to how the valuation analyst applies their skills, knowledge, and judgment to the project. The scientific tools in their toolbox are all informed by what the valuation analyst brings to the table, including: 

  • Ability to ask the right questions
  • Understanding of proper context
  • Experience in the valuation industry
  • Interpretation of financial statements
  • Experience working with similar businesses
  • Judgment regarding appropriate approach/method
  • Common sense, reasonableness, and objectivity

All of the scientific approaches still need to be filtered through the “arts” listed above. Which earnings metric should be used in the income approach? How should data for comparable transactions be refined using the market approach? Is the asset approach relevant, or should it be disregarded given the circumstances?

A business valuation without human judgment applied has little value. This is one reason why using an online business valuation calculator can be a poor substitute for working closely with a valuation professional.

The downside of the art involved in business valuation is that it leaves a lot of room for interpretation. You can ask 10 valuation professionals to value a business and get 10 different answers. Most of the answers will cluster around a narrow range of values, while a few outliers will appear on the high and low ends of the range. (I witnessed this firsthand during a NACVA course.)

No Two Business Valuations Are Alike

Valuing a business is a bit like threading a needle: It can be difficult — maybe even impossible — to get it exactly right. All valuations are hypothetical up until the exact moment that a transaction takes place. At that point in time, the value of the business is known. Before and after that, it is anybody’s guess.

With that said, a valuation report done by a skilled professional can get you pretty darn close. The key is to find someone who has the right background and experience to value your business. The devil, as they say, is in the details.

Case in point is a company for which Allan Taylor & Co. did a Broker’s Opinion of Value. Our goal was to determine an estimated sale price for the business. At the same time, a disgruntled partner was having their own appraisal done by another firm.

The business being valued received 90% of its annual revenue from residential property management and the other 10% from residential real estate sales. We pulled recent transaction data using NAICS code 531310 for Real Estate Property Management companies. The other firm used NAICS code 531210 for Offices of Real Estate Agents and Brokers.

[The NAICS or business activity code can be found on the first page of a company’s tax return, although the valuation specialist may choose one that is a closer match to the company.]

As often happens, the two different values for the same business came back light-years apart — one number was almost half of the other!

Upon further inspection, it became clear that the biggest difference between the two valuations (both using the market approach) came down to the NAICS code used. 

RE Brokerage (531210) versus RE Property Management (531310)*

  • Sell for 25-35% of annual revenue versus 100% of annual revenue
  • Sell for 3.5 times EBITDA versus 3-5 times EBITDA 

This is just one example of how a single input — informed by the experience and judgment of the valuation analyst — can make a big impact on the outcome.

Work With an Experienced Valuation Specialist

If business valuation methods were as simple as plugging numbers into a spreadsheet it would end there. But like every aspect of small business, there are a number of moving parts that deserve careful evaluation by a trained professional. 

A good business valuation gives you clarity around your business worth, but it is much more than a number. The valuation process sheds light on the strengths and weaknesses of both the financial and operational health of your business. A valuation is always the starting point for any plan to sell or exit your business. And it can also be used to make management decisions today and build personal wealth for tomorrow. 

The advisors at Allan Taylor & Co. are ready to help you understand the value of your business and discuss a future sale. Are you ready to start the conversation? Reach out today

*Source: Business Reference Guide, Business Brokerage Press, Inc.

Barbara Taylor is the co-founder of Allan Taylor & Co. You can follow her on LinkedIn and Twitter.

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