The old saw is that a business is worth what someone is willing to pay for it. All it takes to sell a business is for the owner to find one person or company who offers something that the business owner is willing to accept. But, that’s not very informative if you want to know what your business is worth. How does one decide what a fair price is for a business?
Business finance is a complicated subject. You could get a whole Master’s degree on the topic and still just be scratching the surface. It wouldn’t be practical to try to cover all of that material here. What follows is obviously a simplification; our goal is to give you a general sense for the process. If you urgently need to determine the value of your business, then you should consult a small business attorney and get a referral to a reputable business broker.
Valuing a Public Company
The easiest way to buy a business is to buy shares on the stock market in a publicly traded (“public”) company. When you buy a share, you own a tiny piece of the company. The value of that share is determined by the trading price in the stock market, and it can go up or down, affected by a variety of factors (company results, industry news, analyst reports, economic conditions, rumors). If you want to know the value of the whole company, you need to look at the “Market Capitalization” of the company. The Market Capitalization is simply the share price multiplied by the total number of shares. If you want to know what Home Depot (or any public company) is worth right now, just Google “Market cap of Home Depot” and see what you get. For fun, try again in a few hours and see if it has changed. Or, go to Yahoo Finance or any equivalent site and look up the company. Determining the value of a public company at any moment in time is easy. The hard part is guessing what that company’s value will be in the future. Wall Street analysts earn their sizeable salaries by analyzing public companies and predicting whether their price will go up or down in the future.
Valuing a Large Private Company
Large companies (both public and private) face a lot of pressure to grow. If they don’t grow, then shareholders don’t get much from owning the shares, so shareholders push them to find ways to grow. One of the surest ways for a large company to grow is to buy smaller companies that are growing quickly (“merger & acquisitions” or “M&A”). This is why gigantic companies like Facebook and Google often acquire other large or rapidly growing companies.
When a large company buys another company, it typically sends a team of M&A specialists to evaluate and price the company in a process called “due diligence.” This M&A team has a process for determining the value of the target company. They usually use one or both of the following methods:
Method 1: Discounted Cash Flow Analysis (DCF)
Discounted cash flow analysis (DCF) is a mathematical method for determining the value of a company by estimating the cash that the business is expected to generate in the future. There are commonly agreed practices for this analysis; nevertheless, two analysts can still come to very different numbers for the same company because they make different assumptions. This method is too complicated for us to describe here.
Method 2: Comparables Analysis (“Comps”)
The second method is similar to what your real-estate agent does when it’s time to sell your house. The agent looks at all of the other similar (or “comparable”) houses that have sold in your area and then uses a factor (or “multiple”) on your house. For example, if the similar houses in your area have been selling for about $300 per square foot, and your house is 1,000 square feet, then the realtor might say your house should go on the market for 1,000 times a $300 multiple, or $300,000.
We do the same thing for companies. First, you need to find a reasonably comparable company. The best comparables would be specialized toolmakers that had sold recently. If you knew the sale price and the company’s EBITDA (“Earnings Before Interest Taxes Depreciation and Amortization”), then you could figure out the “multiple” for the sale. For example, if the company’s EBITDA in the last annual reporting period was $1 million, and the company sold for $8 million, then we would say it sold at an 8X multiple. (The price was eight times the EBITDA.)
Unless you are in the business of brokering companies, it can be hard to find a private company’s sales price and EBITDA. So, let’s use public companies as a quick-and-dirty substitute. Find some publicly traded companies that sell specialized tools. Snap On (NYSE:SNA) and Stanley Black and Decker (NYSE: SWK) are examples. Go to Yahoo Finance (or any equivalent site) and look up the Market Capitalization of one of the companies. Then, click on the Finance tab and look up the EBITDA for the past year (sometimes labeled “TTM” for Trailing 12 Months). Assuming that the company is not losing money, the Market Capitalization divided by the EBITDA will give you a multiple. On the date that we did this, the multiple for Stanley Black and Decker was 8.9X, and the multiple for Stanley Black and Decker was 8.2X. So, you might say that on that day, a specialized tool company could sell for about an 8.5X multiple. Figure out your company’s EBITDA for the past year, and multiply it by 8.5, and you’ll have a very rough idea of the value of your business.
Once you know where to look, the comparables method is pretty easy. However, the rough value is just a starting point. When you are selling your house, the offer price is just a starting point. You expect the buyer to try to convince you to accept a lower price. In the same way, when someone wants to buy your company, expect them to claim that your comparables aren’t really comparable, and let the negotiating begin!
Valuing a Small Private Company
Determining the value of a small business is especially challenging. Often, it is difficult to find comparable companies that have sold recently (and huge public companies really aren’t all that similar), so it’s tough to agree on a value. Also, many early-stage businesses have revenue, but no income – that is, they are not yet profitable. So, given that company value is usually based on earnings (EBITDA), agreeing on a value for a company with negative earnings is tricky. Often, such companies sell for 1X revenue. That is, if your company made $100,000 in revenue in the past year, the buyer might offer you $100,000 for the company.
What is “Book Value”?
When you look in the accounting system for a small business, you will see something called “Book Value.” This is a value that is created by the accounting system, following certain rules. It is meant to show what you could get for the assets if you liquidated the company. It’s similar to the “Assessed Value” that you will see for your home. The assessed value is usually based on the price the last time the house was sold (probably when you bought it), and it is used to determine how much property tax you pay. However, there’s not a very close relationship between your house’s assessed value and the price you could get for it on the market. In the same way, there’s not usually a close relationship between a company’s book value and the price it could get from a buyer.
Another important consideration when you are purchasing a business is whether the business has any debt. Often, small businesses do not have debt because they are unable to qualify for loans. If they do have debt, however, that needs to be subtracted from the value. If the company has any special assets (machinery, patents, trademarks, trade secrets), they may be added to the value. As you can see, determining the value of a business is an involved process.
While it is fun to speculate about the value of your business, in order to actually realize that value, you need to find someone (or a company) that wants to buy your business. If you want to prepare for that eventuality, then it pays to do some research on various types of exits. You might be interested in our earlier post on exit strategies. You should also learn more about the types of investors. To learn more about valuing companies, try this quick primer from Harvard Business School Online. The best way to build a company that someone else wants to buy is to focus on creating value for your customers. If you provide what your customers need, that will lead to many opportunities.
Misamore, B. (2017, April 21). How to value a company: 6 methods and examples. Harvard Business School Online. Retrieved on September 14, 2022, from https://online.hbs.edu/blog/post/how-to-value-a-company
What is an “exit strategy,” for a business, and why do I need one? (2022, July 11). Ask Zenagos Blog. Retrieved on September 14, 2022, from https://zenagos.com/what-is-an-exit-strategy-for-a-business-and-why-do-i-need-one/