How to Value a Small Business
There are over 33 million small businesses in the United States. As such, small businesses are the heartbeat of America’s economy. In addition, small businesses come with many benefits for business owners. This includes significant financial gains, flexible schedules, and opportunities to make a meaningful impact on people. If you are preparing to buy, expand, or sell a small business, it is important to learn how to value a small business. This can help you understand how to find success whether you are buying, growing, or selling a business.
To learn how to value a small business, it is best to obtain a business valuation. During a business valuation, a valuation expert determines the fair market value of a small business. In addition, business appraisers highlight the risks and opportunities of your small business. This information is crucial if you are looking to maximize the value of a business.
Peak Business Valuation, business appraiser, works with thousands of small businesses throughout the nation. We are happy to provide you with a business valuation for a small business! Additionally, Peak can discuss any questions you may have on how to value a small business. Start now by scheduling your free consultation with Peak Business Valuation below! Check out Valuing a Small Business for more information.
How to Value a Small Business
Business appraisers consider a variety of business valuation methods when valuing a small business. At Peak Business Valuation, the most common methods are the market approach and/or the income approach. Both approaches are effective, however, each method uses a different basis of valuation. As part of a business valuation, the business appraiser determines the most applicable valuation method for your small business. This can involve using a combination of valuation approaches for valuing a small business.
Valuing a Small Business Using the Market Approach
The market approach is one of the most common valuation methods for valuing a small business. This valuation method is similar to how a real estate appraiser values a property. During a real estate valuation, the real estate appraiser compares similar homes that recently sold in the area. This helps them accurately determine the value of a property. Similarly, when valuing a small business with the market approach, business appraisers look at comparable businesses that recently sold. If the small business is private, the valuation expert refers to private transaction databases for relevant information.
Multiples for a Small Business
Valuation multiples are a key component of the market approach. These are financial ratios that measure a small business’s value based on various metrics. Common valuation metrics include earnings, cash flow, or sales. To find the proper valuation multiples for a small business, business appraisers apply the appropriate NAICS or SIC code. Below, we discuss SDE, EBITDA, and REV multiples for a small business.
SDE (Seller’s Discretionary Earnings) Multiples for a Small Business
- The SDE multiple measures the value of a small business by assessing its seller’s discretionary earnings. This is a common valuation multiple when valuing a small business.
EBITDA Multiples for a Small Business
- The EBITDA multiple reflects a small business’s earnings before interest, taxes, depreciation, and amortization. This helps the business appraiser determine the small business’s return on investment.
REVENUE or SALES Multiples for a Small Business
- REVENUE or SALES multiples represent the total amount of sales a small business makes. Business appraisers can calculate the value of a small business by applying the multiple to its revenue or sales.
To learn more about how to value a small business using valuation multiples, see What is a Valuation Multiple?
Valuing a Small Business Using the Income Approach
The income approach is another common valuation method for small businesses. This approach assesses the future cash flow potential of a small business. In addition, the income approach analyzes the risks associated with buying, growing, or selling a small business. Below, we discuss a few common risks for small businesses.
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- Financial Performance: Small businesses are prone to financial instability. As such, business owners should take careful measures to ensure steady cash flow.
- Competition: In most industries, there are millions of other small businesses to compete with. To succeed, it is important to create diverse revenue streams to differentiate from competitors.
- Regulations: Regulations for different industries can change often. Small business owners need to be aware of and comply with industry standards to avoid any penalties or damages.
- Owner Dependency: Many small businesses rely heavily on the owner of the business to succeed. However, the most valuable small businesses are those with low owner dependency.
Methods to Value a Small Business Using the Income Approach
There are various ways to use the income approach to value a small business. The most common income approaches are the capitalization of cash flow method and the discounted cash flow method. In the following paragraphs, we discuss how to value a small business using the capitalization of cash flow method and/or the discounted cash flow method.
Capitalization of Cash Flow Method
- The capitalization of cash flow method is best for small businesses with long and stable histories. When using the capitalization of cash flow method, valuation analysts determine a reasonable amount of income for one period. The income is then divided by a capitalization rate which represents the rate of return investors can expect. The capitalization of cash flow method also considers any risks that may prevent investors from meeting expected earnings. We discuss a few of these risks above.
Discounted Cash Flow Method
- The discounted cash flow method is ideal for small businesses with strong financial histories. This method is also beneficial for businesses with reliable forecasts. The discounted cash flow method involves projecting future cash flows over a 3-5-year period. Business appraisers then apply a discount rate that takes the time value of money into account. Keep in mind, the discounted cash flow method is less common since it relies on future income estimates which can be inaccurate.
Summary
If you are looking to buy, expand, or sell a small business, it is helpful to understand how to value a small business. When valuing a small business, valuation experts consider various valuation approaches. To understand which method is best for your small business, obtain a business valuation. During a business valuation, you will discover the fair market value of a small business. Additionally, business appraisers highlight the strengths and weaknesses of your small business. This information can help you take the next steps to increase the value of a small business.
Peak Business Valuation, business appraiser, is happy to help! We frequently work with small businesses throughout the nation. As such, Peak can provide you with a business valuation for a small business. We can also answer any questions you may have on the value of a small business. Start now by scheduling a free consultation with Peak Business Valuation below!
See also Valuing a Small Business.
