Whether you are looking to sell your business, looking for outside investors or just want to know where you stand, knowing the value of your company is certainly a critical figure.
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The important factor to understand is that there isn't one magic number that your company is worth.
There is a variety of valuation methods used to determine the monetary assessment of a company. Each of these methods will provide a different figure and ultimately, the value of the company is what someone is willing to pay for it. In this two part article, several common valuation methods will be discussed, which should provide the small business owner with a range of values for their business.
Owner Benefit/Salary Method
This a very basic valuation method used for evaluating small businesses. This method takes the owner's total benefit, or salary, and multiplies it by the multiplier 2.2727. This method depends heavily on the salary or dollars that owner of the small business takes home annually. This valuation can be increased, for example, if the business owner can reduce their COGS and increase the dollars the owner receives.
Tangible Assets (Balance Sheet Method)/Asset Valuation
This method assigns a value for the company based on the assets listed on the balance sheet. A business without many assets or a company that outsources production would not want to use this method due to limited assets on their balance sheet. This method is commonly used, especially when businesses go bankrupt.
Capitalized Earnings Method of Valuation
This is a popular valuation method, which bases the company's valuation on what an investor could reasonably expect to return. With this valuation method, the company's Earnings before Interest and Taxes (EBIT) is divided by 25%. This method will provide a higher valuation figure if the small business can reduce their COGS, thus increasing Gross Profit and ultimately EBIT.
Multiplier of Market Valuation
This valuation method uses an average sales figure, using sales from comparable businesses as a multiplier. The multiplier is multiplied by the annual gross sales to compute the value of the business. This method is not widely used, but a small business owner looking to sell their business should be aware of its existence, in case a buyer chooses to use this method.
Cost of Creation Method of Valuation
This valuation method is used when the potential buyer is purchasing the company in order to save on start up time and costs. For example, an entrepreneur looking to start up a restaurant could avoid many start-up costs by purchasing an existing restaurant. This valuation method requires the buyer to estimate his/her start up costs. They then subtract what they still need to purchase and a premium for the time they save from purchasing the existing company. If a small business is being bought out by a buyer looking to enter the market, this method is commonly used.
This article is continued with additional valuation methods and discussion in the second article: Valuating a Company.