How to Calculate the Value of your Business

Have you ever wondered how do you actually calculate the value of your business?

• Maybe you are just curious; you want to understand how business valuation works.
• Or maybe you are thinking of selling your business, so you want to know how much it is worth.

Whatever your reason may be, you need to know how to calculate the value of your business:

There are 4 ways to calculate the value of your business.

These are the Asset Based method, the Cash Flow method, Revenue/Earnings method, and the Market Comparison method.

The best method for you will depend on your assets, your industry, and your competitors. 

In this blog, I break down the fundamentals of each of these 4 business valuation methods.

I also talk about the positives and negatives of each of these methods.

By the end of this blog, you’ll have a better understanding as to which method is right for you.

Asset Based Method: Explanation

The premise of this method is simple: It looks at all your recorded assets and your liabilities.

• Your assets are anything that can be converted to cash: property, equipment, inventory, etc.
• Your liabilities are any debts you have: commercial lease, loans taken out for equipment, etc. 

The business valuation formula is as follows: Business Value = Assets – Liabilities.

For example: If assets = $100,000 and liabilities = $30,000 then business valuation = $70,000.

However, you will also need to factor in economic aspects such as inflation and depreciation.

• Inflation refers to the general increase in prices and fall in the purchasing power of money.
• Depreciation refers to the reduction in the value of assets over time, due to wear and tear.

For example, machinery purchased for $100,000 today will not be worth that in 5 years’ time.

Also, machinery that you could buy today for $100,000 will cost much more in 5 years’ time.

Asset Based Method: Pros/Cons

There are a number of positives and negatives regarding this asset based method.

In terms of pros, this method is preferred when others result in giving you a lower valuation.

It is also the most straight forward method: Business Valuation = Your Assets – Your Liabilities.

It’s also best for companies that have assets that gain value over time instead of depreciate.

For example, if your business owns a lot of property, this will increase the value of your assets.

As for cons, this method may not account for all the ‘intangible’ assets of your business.

Intangible assets include things like the intellectual property, trademarks, patents, brand, etc. 

As anyone knows, a business is worth much more than just its ‘tangible’ assets. A business may have identical tangible assets to another business, but it’s the brands that set them apart.

Also, this method would not suit small companies that do not have a lot of tangible assets.

Discounted Cash Flow: Explanation 

This method focuses on the future performance of your business instead of its historical data.

If your cash flow is consistent, your business may be likely to be worth a much higher value.

This method estimates the cash flow that your business is projected to produce in the future.

It then ‘discounts’ it back into its current value (also known as net present value or NPV).

As well as that, it accounts for the financial risk associated with the business in your industry.

For example, a high tech software business is considered higher risk than a retail clothe store.

However, a high tech software business also tends to be worth more than a retail business.

Discounted cash flow aims to work out what your future cash flow would be worth today.

It is based on the assumption that $1 today buys more than $1 tomorrow, due to inflation.

It is said that this method of valuation is the method of choice for investors like Warren Buffet.

Discounted Cash Flow: Pros/Cons

There are many pros and cons related to this valuation method.

In terms of pro, many founders prefer this method because it focuses exclusively on cash flow.

This is often regarded as an influential factor in determining the value of a business. 

Normally the discount rate can be anything from 15-25%

As mentioned, it tends to be the valuation method of choice for experienced investors.

As for cons, this method is based on many estimates/projections of cash flow into the future.

If those figures are slightly off/unrealistic, this could have a terrible valuation for the business.

For example, it could be overinflated, as was the case with the coworking company WeWork.

However, it may be underestimated, meaning that it could be valued lower than should.

As is said with investing, past performance is not an indication of future performance.

Revenue/Earnings: Explanation

This method uses the business revenue (gross income) or earnings (net profit after expenses).

It then uses an ‘industry multiplier’ to come up with a valuation for your business.

For example, if your industry multiplier is ‘5’, and your sales revenue last year was $100,000, then your business would be valued at $500,000 using this method. Easy and straightforward.

This method is quite common with internet businesses, where the industry multiplier is 35!

However, they would multiply this figure by the business monthly reoccurring revenue (MRR).

For example, if you earn $4000/month x 35 = $140,000 would be how much it’d be worth.

An alternative version examines your current and future earnings, and then uses a multiplier.

The measure for earnings can either be EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation, and amortization).

Revenue/Earnings: Pros/Cons

There are multiple pros and cons regarding this valuation method. Starting off with pros, this method offers an easy and straightforward way to establish a rough value for your business.

As mentioned, this method is most common when it comes to valuating an internet business.

 The industry multiple is as high a ‘35’ multiplied by your reoccurring monthly revenue.

Therefore the more you earn from your business, the more it will be worth when selling.

As for cons, its mainly regarding the alternative version of this method, involving predictions.  

Because this method involves making projections about the future revenue of your business, which may fluctuate for many reasons over the years, it is not as precise as other methods. 

For example, a national/global recession or pandemic may create a sudden decrease in sales.

Whereas the closing of a nearby competitor would give your business a large increase in sales.

Market Comparison: Explanation        

The fourth method of valuation compares businesses within the same market that have similar customers to yours, that generate revenue and/or earnings similar to your business.

For example, if you have a small retail shop, you could research other retail stores within a 10-20 mile radius of your location to see what their businesses have sold for in recent years.

Also, let’s say that you found 10 other retail stores with an average selling price of $100,000.

This would mean that you could use $100,000 as a valuation based on the market comparison.

However, that is making the assumption that you have one retail store within your business.

Whereas if you have multiple stores, then you need to find other businesses similar to yours.

In this scenario, you may need to expand the net further; 30-50 miles instead of 10-20 miles.

When comparing markets be wary that market comparison will vary from location to location.

Market Comparison: Pros/Cons

As with the other valuation techniques, there are many pros and cons related to this method.

In terms or pros, this method would give you a quick and easy estimate of the value of your business if the sale prices of how much other similar businesses are selling for are available.

This method doesn’t require you to calculate your assets, cash flow or your revenue/earnings. 

All you would have to do is research how much similar businesses in your area have sold for.

In terms of cons, this method is not as precise as using assets, cash flow, or revenue/earnings.

This is because it may be difficult to make exact comparisons with privately owned businesses.

While some information is available, not all info about your competitors is readily available.

Another con is that it is unlikely that you’ll just use this method for your business valuation.

You can use this method to get a feel for the market, but use another method to back it up.

Final Thoughts        

So whether you are preparing to sell your business, need a valuation for insurance, or just curious about what your business is worth, you need to know your business’ valuation.

There are many online valuation calculators that provide you with an estimate. They may use any of these 4 methods: Asset Based, Cash Flow, Revenue/Earnings, or Market Comparison.

You can find one here at Company Valuation Services. Not sure what method it is using though

My personal favourite is the Revenue/Earnings method. It’s your MRR x Industry Multiplier.

For online businesses especially with a 35x multiplier, it’s a great business valuation method!

I hope you’ve enjoyed reading this blog about How to Calculate the Value of your Business.

If you enjoyed reading, check out my other blog: What we can Learn from The Dropout.

If you have any suggestions for future blog topics, please share in the comments below!