Owning a small business isn't like owning stock in a publicly traded company. With stocks, you can always calculate the market value of the entire business just by multiplying the market price of the stock by the number of outstanding shares. However, small-business valuation can be tricky, and you'll need to take into account factors like revenue, cash flow, and future growth estimates in order to put a reasonable dollar figure on a business. Depending on the industry and the level of risk, valuations can vary greatly from business to business, but here's a closer look at what you'll need to know to get started.
1. Know what your business earns.
The first step to valuation is to understand how profitable your business is. In some industries, revenue is more important than net income, but the proof of a business is whether it can make money.
However, some accounting practices can obscure true profit. Items like depreciation and amortization reflect reductions in value of business assets, but they don't always match up perfectly with the true deterioration in the usefulness of such assets. Similarly, taxes can vary greatly from year to year based on available tax breaks. In order to make it easier to evaluate, many valuation methods start with earnings before interest on debt, taxes, depreciation, or amortization -- also known as EBITDA.
2. Estimate how your business is likely to grow.
Most businesses grow over time, and the faster the earnings growth, the more the business is worth. It's difficult to project growth, but by looking at past trends, you can typically come up with a reasonable estimate of future earnings gains.
In addition to how much your earnings will grow, you'll also want to know how long your business will keep making money. Many businesses have indefinite lifespans, but some come with fixed dates after which the opportunity disappears. Those limited-life businesses are worth less than if their streams of income continued into the future, but that doesn't mean they have no value at all.
3. Evaluate risks and determine any discounts for marketability.
Small businesses always come with risk, but the amount of risk depends on the industry. Some businesses have stable prospects and little competition, while others face huge challenges along with the opportunity for immense growth. With valuation methods like the discounted cash flow method, those risks get taken into account by discounting future earnings at a certain percentage rate. The greater the risk, the higher the discount rate, and the more important earnings in the near future become, compared to earnings far in the future.
In addition, a small business is hard to sell, because you have to find a willing buyer. In some cases, that would require a business owner to take a discount from recognized valuations. Moreover, if you own only a portion of a small business, marketability concerns get even bigger, and that can require an even larger discount.
Putting it all together
Once you know all these things, doing the calculations isn't all that hard. The following calculator can give you a good rough estimate of valuation based on some simple assumptions.
Editor's note: The following language is provided by CalcXML, which built the calculator below.
To see how this works, let's start with a basic example. Say that a company brings in $100,000 in EBITDA now, and it expects to see 5% growth over the next 10 years. The business faces an average level of risk, and the owner wants to assume a 10% discount for lack of marketability.
If you run those numbers through the calculator, you'll see that it puts a value of $736,500 on the business. Even though earnings will grow from $100,000 to more than $155,000 over the 10-year period, the discounted value of those future earnings will fall to about two-thirds the current level by year 10. Adding up the discounted EBITDA figures gives $818,000, and subtracting the 10% marketability discount gives you the final number.
Be smart with valuation
In the end, small businesses are worth what owners are willing to sell for and buyers are willing to pay. However, by using simple valuation tools like this one, you can find a starting point for negotiations, or just get a rough idea of the value of your business. For many small-business owners, that value is the result of years of hard work and sacrifice to create the successful venture they currently have.
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