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How to Value a Business – The Free Business Valuation Calculator
Every business owner should have a good idea of what their business is currently worth, even if they have no plans to sell it soon or at all. But you may also need to know how much the company is worth in the following non-exhaustive list of circumstances. How many reasons do you have to find out what a company is worth?
- Buying a business or division externally or internally
- Selling a business or department externally or internally
- Shareholder/partnership agreements and purchase/sale
- Estate and pension planning
- Family law – divorce and prenup
- Structuring a business insurance policy
- Structuring personal insurance
- Actual death or disability of owner(s).
- Legal proceedings as plaintiff or defendant
The problem is that company valuations are a complex mixture of science and art, further confounded by the ‘stock prices’ shown by business brokers and their often flawed ‘rules of thumb’ methods that make no commercial sense. The steps for valuing a business are fairly simple, but must be followed diligently.
The transfer price of any business (or any asset) will almost always come down to an agreed price between an informed and willing but not anxious seller and an informed and willing but not anxious buyer. The purpose of the valuation is therefore to show the seller and/or the buyer what price would represent a favorable financial outcome for them, given the required rate of return. The purest method of valuation is the discounted cash flow (or net present value) approach, but this method requires accurate knowledge of all cash inflows and outflows from now to infinity for the company. While this method is great for some financial assets with guaranteed cash flows, it cannot be used for companies with variable cash flows.
The next best alternative used by most business valuers is a modification of the above method called the capitalization of future retained earnings method. This method requires the appraiser to predict the most likely annual profit figure (earnings before interest and tax), which will then be used as the annual recurring amount in the calculation. The appraiser then applies a capitalization rate to these earnings based on the required rate of return to provide a value to the business.
Future sustainable earnings (profit)
Earnings will usually be calculated based on past business performance and taking into account estimated projections. Net profit from the financial statements is adjusted to take into account various factors that are artificial or non-commercial amounts in the financial statements.
Adjusted earnings before interest and taxes (EBIT) for each past and projected year are then weighted based on certain assumptions to form weighted average EBIT or future sustainable earnings, which is considered the likely annual recurring amount of future earnings based on the method and assumption used .
The capitalization rate is inversely proportional to the required rate of return on investment in the company. The higher the required rate of return, the lower the capitalization rate and thus the lower the value of the business. Conversely, if there were no risk in investing in the company, the required rate of return might be as low as 5%, and the company would be valued at 20 times future sustaining earnings. Although this is almost never the case, as there are many risks associated with running a business. More likely, the required rate of return would be between 15% and 100% with corresponding capitalization rates between 7x and 1x respectively. The higher the risk, the higher the return an investor would need compared to the investment outlay for the investment.
Since the future maintenance profit is already calculated, the only way to change the value of the company is to change the required rate of return. The higher the required rate of return, the less the company is valued for the same level of future revenue that can be sustained.
In the free business valuation calculator I created on my website, there are only 7 factors that affect the required rate of return. Note that this is an oversimplified example, as in practice the number of factors could exceed 100 in total. Responses to these factors have a significant impact on the estimated value of the company and are all related to business risks.
Based on assumptions
Company valuation is a complex science that requires a tremendous amount of information gathering, due diligence and industry knowledge to provide an accurate value opinion. Due to the limited scope of any basic business valuation calculator, the following or similar assumptions are typically used. These assumptions may or may not be accurate and will depend on the specifics of each company.
- The information provided by the company is correct in content;
- The past is a good indicator of future business performance;
- Economic, industrial and geographic factors are stable;
- Key customers, suppliers and employees support the transaction;
- All transactions with related parties are at fair value, except as specifically identified in the adjustments;
- All inventory, plant, equipment, fixtures and fittings necessary for the operation of the business are included;
- All depreciation amounts are book entries only and no significant asset updates are required in the near future; and
- All necessary intangible assets and regulatory approvals are transferable.
How to calculate a good name
Goodwill is simply the difference between the value of the business and the values of identifiable net tangible assets (excluding bank loans and other borrowings). If the fair value was greater than the net tangible assets, you have that much goodwill, but if the fair value was less than the net tangible assets of the company, the company would have negative goodwill and the assets would have only realizable value.
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