Determining the value of a business can be complicated. There are many way to value a business. It depends upon type of business as well as many other factors. Specifically how is business value determined? In a recent chat for USA Manufacturing Hour on Twitter, host Damon Pistulka, a business valuation expert from Exit Your Way in Washington led a valuable discussion about business valuation fundamentals.
Methods Used to Value A Business
There are many methods used to value a business. These methods vary widely based on the purpose of the valuation and level of confidence needed. The discussion began with participants sharing their thoughts on what the most common methods used to develop business value are.
Julie Basello from Radwell International in New Jersey said, “Sales revenue and physical assets (inventory and real estate).”
Dan Bigger from Optessa Inc in New Jersey said, “I have no idea.”
Ruby Rusine from Social Success Marketing in California said, “Same here! No idea.”
Pavel Stepanov from VirtuDesk said, “Methods to Develop Business Value -Income -Market Capitalization -Asset Valuation.”
VirtuDesk said, “Assets and income for us.”
Rebecca Prox, a Digital Marketing Professional from Wisconsin said, “I suppose this would include things such as equity, assets, and even who knows your business and why (reputation).”
Whitney Koch from Welker, Inc. in Texas said, “Like that you included reputation!”
Amy.M.Anderson said, “Several brand names have been acquired because of their reputation. Pity the acquiring group didn't maintain the reputation...”
Prox said, “Thanks! It's an intangible way we measure value, don't you think?”
Koch said, “Yes! I think it’s important to consider the intangibles too.”
Felix P. Nater from Nater Associates in North Carolina said, “I like this answer. How often do we discuss intangibles as either an ROI or a business inhibitor as it relates to toxic people and their negative business devaluation?”
Koch said, “This is a new topic to me, so I am here to learn today. Putting my learning cap on.”
Missy Moorefield from Southern Fasteners & Supply in North Carolina said, “Uhh... I'm just gonna check out some of the other answers here.”
Kelly Plats from NACL in Ohio said, “Reviewing the financial information - cash flows, assets, receivables, debts, market share.”
Host Pistulka said, “Awesome answers.”
Nigel Packer from Pelatis Online in Wales, UK said, “Lots of accountants in the answers below. No mention of customer loyalty, Intellectual property and employees. There is more to valuing a business than putting a price on the physical.”
Host Pistulka said, “The most common valuation methods are multiples of sales or earnings developed from comparable transactions of similar businesses. The multiples estimates come from aggregated private business transaction data with benchmarks to ensure similar businesses are being compared.”
Measures of Profitability
The value of a business is commonly determined by the profitability. Other factors may affect the value, but profitability is the main value driver in most business valuations. The discussion turned to what the measures of profitability used to value a business are.
Bigger said, “Sales v debt.”
Plats said, “Gross Profit – Operating Costs(Selling and Administrative Expenses) = Operating Profit. I remember this one from class. Someone tell my professor that the marketing kid remembered something!”
Koch said, “I took 1 finance and 1 accounting course, so I feel like I should know/remember this. But that was sooo long ago
Plats said, “I took my last finance class last spring and was chatting with that professor last night for a different class and had some mean flashbacks LOL.”
Host Pistulka said, “There you go!”
Prox said, “Measures of profitability include profit margin and return on equity/assets. What might be some others?”
Moorefield said, “I'm thinking one measure is the company makes more money than they spend out.”
Host Pistulka said, “Yes, that is correct!”
Bill Garland, a Manufacturing supporter in New Mexico said, “EBITDA.”
Host Pistulka said, “Yep, you know this Bill.”
VirtuDesk said, “Net sales - cost of goods sold= Gross profit.”
Jasmine Labelle from velavu in Canada said, “Gross Profit!”
Rusine said, “Either of these: There are four measures of profitability used to value a business: return on assets, return on equity, return on invested capital, and return on sales. For small businesses, it's usually the last.”
Stepanov said, “I agree with Ruby on this answer.”
Host Pistulka said, “There are 2 main measures of profitability used when valuing a business – seller’s discretionary earnings (small businesses) - EBITDA earnings before interest taxes depreciation and amortization (common in larger businesses).”
He continued, “This is the starting point. Then the adjustments begin. There are actually dozens of methods to calculate value.”
Koch said, “Is “small business” just determined by number of employees, or is there another classification when it comes to finance?”
Bigger said, “Crap, I did know that one.”
Kirsten Austin from DCSC Inc. in Missouri said, “You truly do learn something new every day! "EBITDA - earnings before interest taxes depreciation and amortization (common in larger businesses)"
Reasons and Types
The way a business valuation is performed is affected greatly by what the valuation is going to be used for. What are the main reasons and types of business valuations? Participants shared their thoughts.
Bigger said, “Reasons: Sale, Passing it on to the next generation, going public, going to employee owned?”
Rusine said, “Would a company merger be one of those?”
Prox said, “Could be used in the sale or acquisition of a business or company, or determines tax rates(?), or can help you figure out the financial goals moving forward. I'm sure there are plenty of others.”
Plats said, “This is beyond me a bit, but I'll guess that there is a difference between valuation for acquisition and valuation for reporting...maybe.”
Moorefield said, “Like other responses I've seen here, sale/merger is the first thing I thought. I also thought valuation could be needed if there's a tax issue.”
Labelle said, “My forté is marketing but let me take a stab at this one! Market, cost and income?”
Garland said, “Three reasons come to mind: 1) Insurance 2) To get a business loan and 3) To be acquired.”
Stepanov said, “Common reasons include sound decision-making, planning, exit strategy, and estate planning.”
Moorefield said, “I can't believe I didn't think about estate planning! I worked full-time as a legal assistant in that area. And am actually still doing some EP document drafting as a side hustle with one of my old bosses.”
VirtuDesk said, “We are not very sure of the specifics since we work on the marketing part.”
Host Pistulka said, “There are many reasons for valuations like knowing approximate value, partnership buy outs, divorce, dissolution, stock option programs, or estate planning/IRS uses. The reasons dictate a certified or limited scope valuation. Certified valuations are significantly more extensive.”
Intellectual Property
The intellectual property can be the secret sauce of your business or some game changing development. Participants next shared their thoughts on how intellectual property (IP) affects the business value.
Rusine said, “We have worked in tech for years and in companies that are pioneers in their industry. When IP is managed well, it can help drive the value of your business.”
Stepanov said, “Intellectual property protects your business assets from copy cats.”
Koch said, “That’s a good question! I would think you would have to include that. Just thinking about parents, which cost a lot of money to get and then defend and can also be sold.”
Bigger said, “I have to assume it escalates it, but to what level I have no idea.”
Host Pistulka said, “That's the big question, isn't it?”
Anderson said, “It effects it enough that my husband actually chose to retire, rather than sign over his personal intellectual property to the new owners of the company he was doing technician work for. (They had hidden a overwhelming IP clause in the new NDC clause).”
Michelle Riccetto from Brash Inc in Canada said, “Intellectual property gives businesses a competitive edge leading to long term viability!”
Labelle said, “I would say it increases the value of the business!”
Adam Baker from Schooley Mitchell in Pennsylvania said, “Based on how it's protected, it could significantly affect the business value up or down.
Packer said, “Oh Good one I can give an insight to. Working for a new start company years ago, we had 6 Patents registered. The value of the company was £500K. With the patents we were offered £35m for the business. The value of IP is considerable. I didn't see any of it!”
Prox said, “Positive valuation when you have intellectual property.”
Nater said, “How is intellectual property determined and by whom? Is there a definition that is applied based on legalities or validated business revenue. Just asking.”
Prox said, “Intellectual property, as I know it, includes things such as trademarks, copyrights, patents, etc. When I've been involved with these things, decisions for such things can come from many different people within a company, not often just one person.”
Garland said, “It makes a huge difference. From what I have seen, IP valuation can fluctuate and quantifying it can be an interesting process.”
Host Pistulka said, “The quantification of the IP value is very challenging and frankly often in the eye of the beholder.”
VirtuDesk said, “It protects the core of the business and can generate income through licensing and commercialization of the protected products.”
Brett from FreightPop in California said, “Intellectual property sets your business apart from your competitors! It gives you a competitive edge and provides your customers with something they can't get anywhere else!”
Host Pistulka said, “In some cases IP affects the business value. IP can be a value driver when it allows the company to make more money and prevents others from using it. The value of intellectual property is usually determined by the market returns it will generate or the value to the buyer.”
Inventory
Every business that uses inventory in the normal course of business has industry accepted norms for inventory $ on hand. Participants discussed how the amount of inventory affects the value of the company.
Baker said, “It depends on the amount of inventory - just the right amount and it could be an asset. If there is too much, or it isn't moving, it could become a liability - especially if it has a shorter shelf life.”
Rusine said, “Waiting for A5...”
Plats said, “Too much inventory can have a negative effect on you overall profitability. Its a cost that isn't being recouped quickly enough.”
Austin said, “Truth!”
Prox said, “Inventory is usually the largest tangible asset of a company. It's what gives value to a business. Too much of it or too little of it could diminish the value.”
Stepanov said, “Your inventory drives cost to your operations. If they are not used wisely, you'll end up losing money. This could lead to a potential money leak as well which is not healthy for your business.”
Garland said, “This can be a bit of wildcard depending on a number of factors. Not all of the products in inventory may be considered sellable. Some products do not age well and excess inventory can be a liability.”
Host Pistulka said, “Inventory value does not usually affect the overall business value because is included in the value based on industry standards If there are extraneous inventory values because of the certain business they may be included in the valuation.”
Rusine said, “Ohhh... I see. So it needs to be done right (not too much-not too little).”
Real Estate
It is common for established businesses to own the property where they are located. Over time this can be a valuable investment for founders. Participants shared their thoughts on how real estate affects the value of a business.
Plats said, “Don't falsify information and bring in someone who knows what they are doing!”
VirtuDesk SAID, “Love that!”
Rusine said, “I agree! Truthfulness and honesty... valuable in life... and in business.”
Koch said, “Hire an expert.”
Prox said, “I would think measuring the last year (12 months)of sales is a good general rule of thumb for a business valuation.”
Host Pistulka said, “It is one of the factors in value. The last 12 months is key.”
He added, “The long-term appreciation of real estate for founders is attractive but real estate is not usually included in the business valuation and separated because the valuation methods are different and real estate value may or may not be needed by the reason for the valuation.”
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