Ever wonder what your business is worth? Here are five common methods of calculating it.
Method 1. Assets vs. Liabilities. This method presumes the result of subtracting liabilities from assets is related to the cost of creating an identical business from scratch. The challenge is identifying and placing a value on non-material items like “Good will” and internal processes.
Method 2. Market Comps. This is based on looking around to see what the “going rate” is for businesses of your type. This is as simple as going to business broker websites and searching for businesses similar to yours.
Method 3. Discounted Future Earnings. This method is based upon “Net Present Value” (NPV) of future earnings. NPV is the reason lottery winners are given the option of taking half the winnings now or a full payout over 20 years. It presumes the proceeds will be invested at some “discounted” rate and the distribution and returns will add up to the jackpot in 20 years.
What is the appropriate discount rate to use for your business? Many buyers will use a “Weighted Average Cost of Capital (WACC)”. This would be the buyer’s interest rate if he/she has to borrow the funds, plus a factor based on the perceived risk. So, discount rates between 10% to 20% are common.
Calculating earnings (profits). For valuing a business, profits are much more than what you expect to pay in business taxes. Consider that your salary is also profit, as are “discretionary expenses” (those not essential to running the business).
An explanation of how to calculate NPV is beyond this article’s scope, but you can go to Google and search for “NPV Calculator”. Also see www.investopia.com for a discussion of WACC.
Method 4: Direct Capitalization. The “Capitalization Rate” is a value used to divide a business economic benefit to arrive at the business value. Capitalization rate is related to the discount rate from Method 3 through the following formula: CR = DR – G , where G is the expected annual long-term growth rate in the business earnings being capitalized. For an explanation and calculator go to http://www.valuadder.com/glossary/capitalization-rate.html.
Method 5. Gross Revenues. Depending on the type of business, its value can be calculated as shown for some typical local businesses:
Eating and Drinking Places / 2X Net Profit or 25 – 35% of annual sales
Beauty Shops / 1.5X Net Profit or 4X mthly sales + inventory
Automotive Repair Shops / 5% of annual sales, 1.5X Net Profit
Business Services / 63% of annual sales
Gift, Novelty, & Souvenir Shops / 4X mthly sales + inventory or 1.5X Net Profit
Computer Related Services / 57% of annual revenue
Retail Bakeries / 4X mthly sales + inventory, furniture, etc
Insurance Agents, Brokers, and Service / 100% annual commissions
Building Cleaning and Maintenance Services / 50% of annual revenue or 1.5X Net Profit
Sporting Goods Stores and Bicycle Shops / 4X mthly sales + inventory
Auto Body and Upholstery Repair Shops / 35% of annual sales or 1.75X Net Profit
Plumbing, Heating, and Air-Conditioning 24% of annual revenues or 1.5X Net Profit
Source: The Business Reference Guide 2002 tenth edition, by Tom West, 2002.