Determine the Value of a Business with 5 Essential Questions

Determine the Value of a Business with 5 Essential Questions

Sooner or later, every business owner will exit their business. When an owner begins to  consider this, the first question that comes to mind is likely “what is my business worth?”  As an exit is planned, the top priorities are to ensure business continuity and maximize value in a transaction; but how is that value measured? Though this is a complex and multi-layered question, a great starting point is  with these five questions:

1. What information can be obtained from the statements?

There are 3 major pieces of information in financials that should be examined closely to obtain an idea of business value. The first is the earnings before interest, taxes, depreciation, and amortization (EBITDA). This is a measure of a company’s current operating profitability, or how much profit it makes with its present assets and operations. The second is the seller’s discretionary earnings: the pretax and pre-interest profits before non-cash expenses, the owner’s benefits and personal expenses, and any other non-related income or expenses. The third is the net asset value, or the value of assets minus the value of liabilities.

2. How does a company’s historical margins benchmark against other companies in the same industry based on industry-specific metrics?

Benchmarking against others in the same industry is a very important component for determining business value. At a high level, you compare historical margins for the past 3 years to industry peers. It is important to pay close attention to specific industry benchmarks used for valuation.

The process of benchmarking begins by comparing (common-sizing) items on the income statement as a percentage of sales and comparing items on the balance sheet as a percentage of total assets. Then you compare those percentages against the averages for companies in the same industry with similar revenue ranges.

These metrics vary a great amount from industry to industry, so it is especially important to get a professional, independent, third party valuation by an investment banker or external valuation expert.

3. Are there any characteristics of a business that would detract from its value?

There are a myriad of things that could devalue a business, from how heavily the business depends on you as its leader to the comparable industry performance to customer concentration.

Customer concentration has a meaningful impact on the value of a business. When a single customer or client accounts for 10% or more of revenue, or when the largest five customers account for 25% or more of revenue, the customer base/revenue is considered concentrated.

When a business is overly-reliant on a small group of clients, its revenue will be highly sensitive. A 10-25% revenue drop can cause a business to go from being profitable to dropping below break-even and threaten its ability to survive. Therefore, a concentrated customer base increases risk for potential purchasers, who value businesses commensurate with the risk involved in their cash flows.

4. How does a company’s projected performance compare against peers in the industry?

If a company is forecasting even better growth and margins than they have had in the past, it’s the quality of the assumptions behind those forecasts that will lend credibility to a business’s future profitability. Ideally, a company’s sales and profit margins should be equal to or above average for that industry, and revenue growth and profitability should be increasing at the same rate or better than the industry average. When an owner understands his/her relative financial performance, it becomes easier to explain to a potential buyer where you have an advantage, and as a result have opportunities for growth.

5. How is the industry as a whole performing?

To help determine the value of a business, it’s essential to know where an industry stands as a whole. What is the market sentiment towards that industry? Resources like the Bloomberg Sector & Industry Performance Report can be an excellent tool to provide a general idea of this.

It’s important to set value expectations on the front-end before approaching the marketplace. To understand what a business may be worth in its current state and in the current market, you will need to understand how companies are valued in the appropriate industry, and how that translates into value for a company. A professional, third party valuation by an investment banker or external valuation expert will help to set value expectations.