Arriving at the culmination of a career and taking the final strides towards retirement is an exciting season of life.
Many business owners have spent years and decades pouring in time, sweat equity, and money to run a successful business. The next step for many is the right strategy to enact an effective exit plan from the business.
When it’s time to put up a business for sale, a financial advisor can be a huge asset in business valuation, or the process of determining the economic value of your business.
The most common purpose for business valuation is to determine the fair market value of the business to purchase or sell it. The fair market value is simply the going rate in the marketplace that people would be willing to pay for businesses of a similar size and scope to your own business.
Business Valuation Methods
There are several methods to value a business to come up with a sale price. In fact, it is very common for a mixture of methodologies to be used or even a hybrid system to get there. Some of the techniques used in a capital budgeting process may also be used in business valuations.
There are many terms for these techniques, but they often fall into these three categories:
- Asset Valuation
- Income Valuation
- Times Average Profits
Put simply, the value of a company is calculated as the net assets of the company.
This could also be described as the book value. The book value of a company is essentially its assets minus its liabilities. This is also called the equity balance. A buyer of a business will typically purchase all the assets that the practice owns, as well as assume the outstanding obligations for what it owes for those assets.
This value may often be adjusted upward by a goodwill amount.
Goodwill is the value that the business places on company assets that are typically more intangible in nature. Instead of being a building and equipment, goodwill represents things like the current customer base, a good reputation, outstanding reviews, and good customer relations. Oftentimes sellers place a value on these intangible assets because they have worked hard to create that value that has enabled the business to be successful.
Income valuation may be calculated in several different ways.
Each of these ways looks at the income that the company will generate for its owners and places a dollar value on that income stream. Some common forms of income valuation methods include the following:
Discounted Cash Flows measure the future free cash flows (FCFs) that will be generated by a business and discount those cash flows to a present value based on its cost of capital. The cost of capital could be the calculated WACC for the company, or it may be the return they would expect from an alternative acquisition or investment.
To measure the FCFs, a forecast is generated for about five years. Once the forecast is generated, the income statement and balance sheet are used to calculate the FCFs that the business will generate for those five years.
As the business is considered a going concern, i.e., it will continue to generate free cash flows beyond the 5-year forecast, a terminal value must be calculated to determine the free cash flows that will be generated beyond the forecast period.
The terminal value represents the NPV of the FCF in future periods assuming the business continues forever.
There are a few methods to calculate the terminal value, with the most common being the Perpetuity Growth Model (also known as the Gordon Growth Model) and the Exit Multiple Model, which values an “assumed sale” of the business.
The Perpetuity Growth Model is calculated by using the FCFs of the last year of the forecast and multiplying it by (1+ selected growth rate), which projects how much the FCFs will grow each year. That number is then divided by the difference between the WACC and the growth rate.
For example, assume a company has the following information:
- FCFs in last year of forecast = $100,000
- Projected Growth Rate = 1%
- WACC = 15%
Its Terminal Value would be calculated as follows:
($100,000 x (1+.01)) / (.15-.01)
$101,000 / .14
The Exit Multiple Model calculates terminal value by estimating a sale price for the business at the end of the forecast period.
That sales price is generally calculated by looking at a comparable company that was recently sold and calculating the ratio of the sales price to a measure such as revenue or earnings and then applying that same ratio to the company being valued.
For example, assume a recently sold comparable company had the following information:
- Sales Price = $2,000,000
- Annual Revenue = $500,000
- Times Revenue = 4x
If the company being valued had revenue of $1,000,000 in the last year of the forecast, the terminal value in the last year of the forecast would be $4,000,000. Once the FCFs of the forecast are calculated, including the terminal value, they are discounted to present value, or the value of the business today.
For example, assume a company has the following information:
Often done in excel, the NPV function is used to calculate the DCF of the future cash flows. In this case, the DCF value is calculated as $439,195.
Note that there is a difference between NPV (Net Present Value) calculations and DCF (Discounted Cash Flows) calculations.
In the NPV calculation, we try to value the project based on an initial investment amount. Therefore, for NPV, we add back the Year 0 investment to the future cash flows. In the DCF calculation, we only calculate the value of the future cash flows to find the amount we would pay for the initial investment to realize an NPV of $0. Thus, we do not add back in the Year 0 initial investment amount.
Times Average Profits
One way of valuing the business is taking a multiple of average profits for the three most recent years. A common multiple is anywhere from 3-5 in most industries. This method is advantageous because it is a fairly easy way to value the future cash flows of the business in a very simple fashion. It is recommended to benchmark your multiple valuations to recent sales of other companies of similar size to ensure you are in the ballpark for the right valuation.
It’s important to note that these various methods are not generally used on a stand-alone basis to come to a hard and fast value for the company. Rather, these methods are collectively used to generate reference points that help come to a “consensus” on a given value of a company. As you can see, some of the methods overlap each other.
TrueNorth Wealth Is Here to Help
Like forecasting, business valuation is both an art and a science. While much of the valuation can be done quantitatively, there are other non-quantitative factors that may also affect the actual valuation of a business.
Here at TrueNorth Wealth, it is our aim to help our clients succeed as they make key financial decisions. We would be more than happy to assist you in this process as you pivot into your dream retirement. Contact us for financing planning in Boise, ID, and throughout Utah!