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How to value a small business if you want to buy or sell

Wondering how you can calculate the value of your small business? Read further to learn some methods that are suitable for knowing the worth of small businesses.

Why do You Need to Know the Worth of Your Small Business?

There are several reasons to determine the value of your business. Some of them are:

  • You want to sell your business at a good price.
  • You want to buy a business.
  • You want to buy a business but need to attract investors for it.
  • You need a bank loan against your business.
  • You need to know the potential value of your business to see its potential growth in the future.

The most common reason to determine the value of any business is to sell or buy it. When you know the worth of a business, you can determine whether you can purchase it or not. Or you can attract investors so that you can purchase a particular business. Also, if you want to sell, you will need a figure to help buyers understand the worth of your business.

Determining the right value for your property is important to either buying or selling the business. Without the value, you will never get an idea of whether you can buy the business. It also creates problems in the future when you will know that the value of your company is more than you have thought. Therefore, figuring out the right value is key to ensuring you don’t get into any trouble.

Also, while there are a number of methods to calculate the worth of a small business, it’s imperative to choose a method that is suitable for your type of business. Note that each method calculates the value based on different factors. You need to choose an evaluation technique that can work for your business. If you haven’t an idea what method you choose, it’s better to get help from financial advisors or business experts, who can help you get the right figure before you make any decision.

More: Three Myths about Buying an Existing Business

Methods to Determine the Value of Your Business

Discounted Cash Flows

One method experts use to value a small business is discounted cash flows. It is the process of evaluating the value of an investment or company based on the cash flow or money you can expect it to generate in the coming years. This method helps you calculate the current value of future cash flows based on the time period of analysis and discounted rate.

The formula used to calculate discounted cash flow is:

Discounted Cash Flow= Terminal Cash Flow / 1 + Cost of Capital X Number of Years in the Future

The primary reason for choosing discounted cash flow is that it shows how much your company can generate liquid assets. But it’s not easy to use this method, as you will need terminal value, and this can greatly vary based on your future expectations about discount rates and growth. So, if you opt for this method to value a small business, you will need expert help who can help you make assumptions close to reality.

Assets after Debt

One of the simplest methods to determine a company’s value is to evaluate what a company owns. However, while doing this, you also need to check what it owes. In general, assets are things of value that your business owns. But if your company has any liabilities, these are the things that it owes. The assets after debt method help you understand the value by calculating the difference between the two.

While being a simple method, it doesn’t indicate the profitability and growth opportunities of a business. However, some businesses like retail can benefit from this trick, as they own extremely valuable assets compared to asset businesses. This method will also work for a business that wants to close its business and sell its assets individually.

A business’s balance sheet will indicate asset book value, which means how much the company has paid for the assets, less any depreciation. Keep in mind that many assets you own may not have the same worth today. Therefore, you can’t adjust these assets from book value to market value. For this, you need to look into the market and check the selling prices of these assets to find their market value.

Market Comparison

Evaluating the worth of your small business seems pretty similar to understanding your home value. If a business with a similar niche operates in your area, you can check its price to determine the value of your business. Hence, a market comparison is one of the easiest ways to calculate the value of your business.

Of course, it will be hard to find a business that is exactly similar to your business. This is because each and every detail of small business sales are not easily available. On top of that, businesses don’t sell as often as houses, so it’s challenging to find one in your location.

When searching for a business, consider some important factors in mind, like the number of customers, the industry, the number of workers, the scale of a business, and the location.

For instance, consider two retail businesses that sell the same products, have the same number of employees, and charge similar rates. If one of them sells for $450,000, you can expect that the other company will also have the same value.

Market Capitalization

This is another method of evaluating a business’s value for owners who are looking for easy methods. Market capitalization is calculated by multiplying the total number of shares of a company by the current price of one share.

The formula is as follows:

Market Capitalization= Total Number of Company’s Shares X Share Value

The drawback of this method is that it only shows the value of equity. But many businesses are financed by a combination of equity and debt. Additionally, the debt indicates investments by bond investors or banks in the future of your company. Note that you need to pay back these liabilities with interest over time. Equity, on the other hand, indicates shareholders who have purchased stocks of your company, which allow them to claim profits.

Price to Earnings Ratio (P/E)

Experts usually evaluate the value of small businesses by their multiples of profit or price-to-earnings ratio (P/E). This method work best for business that has an excellent track record of annual earnings. To determine the right price-to-earnings ratio, you need to determine the profits of your business.

Besides that, if your business has high forecast return growth, then you can expect to have a higher price-to-earnings ratio. On top of that, if your company has an outstanding record of repeat earnings, it will surely have an extremely higher P/E ratio. For instance, if a P/E ratio is five for a business that earns around $200,000, which is post-tax earnings, it will have a value of $1,000,000.

Note that the price-to-earnings ratio for every business can greatly vary from business to business. For instance, B2B companies and tech companies generally have higher ratios. This is because they have more potential for growth and usually grow faster than other businesses. Contrary, businesses like real estate agencies or jewelry stores have lower price-to-earnings ratios due to slower growth and a specific amount of sales.

Since every type of business is different from one another, it’s hard to specify a price-to-earning ratio for every company. But you can expect your P/E to be anywhere between one to ten, depending on the type of your business and its potential growth.

The following are the general P/E ratios for smaller companies.

  • 1 to 2.5 for small, owner-managed companies
  • 2 to 7 for small businesses with earnings of more than $500,000 per year
  • 3 to 10 for small businesses with yearly profits of up to $1,000,000

Entry Cost Valuation

If you want to start any type of business from scratch, the entry cost valuation method is an ideal approach for you. This business value-calculating method gives you an idea of what your business will cost you. Entry coat valuation can also be used to figure out the value of your existing small enterprise.

To determine the value of your business through this method, you need to consider every factor that will help you get your business in its current position. This includes every type of startup costs such as fees for getting the license or charges of legal expenses, tangible assets that you have invested into to establish your business, recruiting and training employees to kick start your business, marketing and advertising cost for brand awareness and visibility, service or product development fees, and other expenses.

Once you determine what initial cost you need to pay for your business, you need to determine which things you can save your money on. For example, you can look for cheaper offices to rent, get the company’s equipment and gadgets from affordable stores, or pay employees the national living wage. Once you deduce the extra things, you will get the total amount of expenses that you need to make. Now, deduct this final figure from the primary startup cost to get an entry cost. It is important to note that you need to be greatly specific by calculating the cost of each expense. This will help you get the right figure at the end.

Bottom Line

So, if you need to determine the value of your small business, there are several methods that you can use. Just make sure to choose the one that is suitable for your business.

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