When valuing a business it may seem logical to value the entire company based on one factor; revenue. Some industries like professionals, hotels, and pubs frequently use this method of looking solely at gross revenue. They have a factor specific to their industry that they multiply by gross revenues to get the value of their business. Because revenue is really the result of all the things a business does, this has the positive effects of ignoring things like the companies method of financing and forcing owners to concentrate on the factors that generate revenue. However, since it only looks at revenues from the last year it is not always a good representation of the long term.

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5 Ways to Value a Private Business

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The cash flow approach to valuing a business looks at future cash flows of the business and discounts them to determine the value present value of the business.

Adjust for Non-Cash Item

You get cash from either the statement of cash flows in the operating cash flows section, or from the income statement by removing non-cash items. The problem with removing non-cash items like amortization is that you lose the anticipated costs that they represent. You’ve got to be aware of this when you are using this method and take it in to account. For example, you could add on a capital asset replacement cost when forecasting future cash flows to compensate for the loss of amortization.

Find a Discount Factor

A discount factor is like an interest rate. If there was no risk, the discount factor would be the same as an interest rate. But it’s more difficult to find the discount rate for a business because there is varying amounts of risk. The method of finding a discount factor is outside the scope of this post, but for reference, you can look at Investopedia for a general introduction to finding this.

Simplified Method – Average Cash Flows

You can just average the out the annual cash flows and divide it by a discount factor. This method assumes the value of the business is can be represented from one cash flow.

Advanced Method – Yearly Cash Flows

The cash flow method of valuing a business involves forecasting cash flows and determining the present value of those cash flows. An investor might use this method when looking at a startup because he can use the forecasted cash flow statements. This method is risky because it is not usually realistic to expect to predict annual cash flows in the future because there is so much uncertainty. You should never go out any further than 5 years because after 5 years the predictions are generally worthless.

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5 Ways to Value a Private Business

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The capitalized earnings approach to valuing a business is the most frequently used approach and is almost always included as part of the consideration when valuing a business. It basically involves taking the earnings of the business and multiplying it by a cap rate, which is like the inverse of an interest rate on an investment, to find the current value of the business. The very simplified formula is:

Earnings / Cap Rate = Value of Business

You need to identify 3 things to value a business this way: The earnings, the cap rate, and any irrelevant assets on the statements.

Normalize Earnings

Finding earnings is not as simple as looking at the net income on the latest income statement. Quite often the latest reported earnings are not the normal earnings. You need to look carefully at the income statement and historical statements to try to approximate normal earnings. For example, an owner of a business may be drawing abnormally large salaries for himself for tax purposes, or perhaps he may have not paid himself for a few years to make it look like the business is earning because he anticipates selling it. You can look at net income, income before taxes, EBIT, or EBITDA. Be sure to use what is typically used in the industry so you can compare accurately. Use your judgment on the circumstances to either calculate an average of the past 5 or so year’s normalized earnings, a weighted average that favors recent years, or just the most current year’s earnings.

Choose a Cap Rate

The cap rate, which is like the inverse of a discount rate, is kind of like the interest rate on an investment. Choosing a cap rate is tricky. All business students spend an entire semester banging their heads on their desks trying to sort out this concept. I’m not going to even try to go there again, but for a reference when needed, here’s Investopedia’s attempt at explaining it.

The basic idea is the more risky the business, the higher the cap rate. If earnings are net income, cap rates are usually about 12% to 25%. If earnings are EBIT then maybe the cap rate would be 20% to 33%. You can also look to the industry for an idea of what cap rates might be.

Consider Irrelevant Assets

When a company is put up for sale, the seller will want to be paid for all the assets. But some of the assets may not be producing income or may not be related to the business. Look through the income statement and balance sheet and see if there is anything there that is not related to the business the purchaser intends to own or operate. For example, a restaurant may own an entire building that is not being used, but still including the value of the building in the sale price of the business. Even if the building is generating income through rent, this is not the same business as the restaurant business and will need to be evaluated as two separate businesses.

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5 Ways to Value a Private Business

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The market based approach to valuing a business is a highly subjective method of valuation. It draws what information it can from the market and applies it to the business.

Use EPS and PE ratios

It’s common to try to use the P/E ratio for the particular business sector the company in question is a part of. You might get this from the FTSE Actuaries Share Indices in the Financial Times. You can then apply that ratio to the metrics of the private company, such as the EPS, to get a rough estimate of the market price of the company’s shares. A formula could be:

Industry P/E *Specific Company EPS = Price per Common Share.

Use Price per User

Subscription based industries, especially High Tech, might estimate how much money each user is paying to the company and use that information to value the company.

Use the Position of the Purchaser

Sometimes the purchaser of a company gains some additional value because of economies of scale, additional sources of revenue, access to new markets, or synergies. In this case the value of the company being purchase is probably higher than it would be if the purchaser was new to the industry.

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5 Ways to Value a Private Business

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An intuitive and very basic way of valuing a business is to look at how much its net assets are worth at fair market value. Balance sheets use historical numbers according to GAPP, but when you are valuing the items on the balance sheet it doesn’t make sense to use historical numbers. Instead you need to look at the market value of the assets and liabilities.

Process

If you add up market values of all the assets and subtract off the liabilities then you will (hopefully) have something left over, which is the owner’s equity and the value of the business according to this approach. You would also need to subtract off any disposition costs such as real estate or legal fees. The other way to do it is to take the equity section of the balance sheet and add or subtract the differences between the historical numbers (reported in the balance sheet assets and liabilities) and the market values.

Formulas

Market Value of Assets – Liabilities – Disposition Costs = Shareholders’ Equity = Value of Company

Or

Shareholders’ Equity (from balance sheet) +/- Market Adjustments for Assets and Liabilities – Disposition Costs = Value of Company

Useful For Full Takeovers

Since it takes time and money to figure out the market values of all the assets, this approach is not realistic in most cases. The only time this approach is generally used is when one company or person is taking over another company in its entirety.

Useful for Asset Heavy Businesses

This approach may make sense if the business’s value is mainly in the assets, like a corner store. It wouldn’t make sense for something like a consulting company where the value is mainly in the expertise. However, it may be accurate if the expertise won’t be transferred with the company. For example, a one-man consulting company would only be worth the net market value of the assets if that one consultant was leaving with the sale of the company.

Goodwill

Goodwill is the amount of value in the company or brand that is not reflected in any material assets. It could be the value in a trademark or location or something like that. In this approach goodwill is not taken into account. It is common for small business to be valued using this method only and if some amount of goodwill to be added if appropriate.

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5 Ways to Value a Private Business

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Determining the value of a private business can be a highly subjective process. Although private companies don’t trade shares, they still need to value their shares for many reasons including everything from raising equity to settling a divorce. Without the open market to determine share prices, we have to use a number of different subjective techniques to estimate the value of a private firm. These are 5 common techniques. No one technique is accurate on its own; you will typically use about 3 of these at a time to make an educated judgment.

Net Assets

This is a very basic approach that looks at the market value of items on the balance sheet for find the fair market value of the net assets, which is considered then the value of the business. It can be costly and time consuming to find the market value of all the assets, so it’s usually only used in a takeover of the entire company. It doesn’t make sense to do it if the businesses value is not mainly in the assets.

Market Based

The market based approach is a highly subjective method that attempts to use information available from open markets to help estimate the price of the non-traded shares. It often looks at similar publicly traded companies and attempts to apply their metrics to the metrics of the private firm.

Capitalized Earnings

The capitalized earnings approach is almost always included in the valuation process. This approach uses the philosophy that a business is worth what it will earn. The concept involves taking normal earnings and dividing it by a cap rate (discount factor). The tricky parts are determining what normal earnings really are, what assets are really parts of the business, and especially choosing an appropriate discount rate, which varies depending on the amount of risk involved.

Cash Flow

The cash flow approach uses a cap rate (discount factor) to figure out the value of the company using cash flows. This can be done by finding an average cash flow and dividing it by the cap rate or by projecting yearly cash flows and discounting them using the cap rate to determine the present value of the cash flows. This could be used to get an idea of what a startup company may be worth.

Gross Revenue

The gross revenue method assumes everything is reflected in the last years gross sales. Some factor associated to the industry is multiplied by the gross sales to get the value of the business.

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