Understanding Business Valuations
Written by Marissa B. on November 11th, 2020
What is a business valuation?
Valuation is the process of assigning value. It is a measure of worth that is arrived upon using standard formulas. Business value comes from assets, processes, financials, profitability, and systems. Prices for business determined using simple math formulas.
Sellers often view their business in terms of the future, but buyers are concerned with more than that. Buyers examining historical data, current data, and projections for the future. Valuation finds a balance using a combination of this financial data and industry data.
How do you determine a business valuation?
Each year or financial quarter, new charts get published. The charts are specific to each region of the world. Each chart consists of an alphabetical list of industries with numbers (multiples) beside them.
When choosing a multiple, be sure to use an up-to-date chart for the right region of the world. Some multiples are very high. Others are very low. Regardless of how big or small the number is, accurate multiples produce fair valuations.
Here's how it works:
Let’s say the EBITDA of a large plumbing company is $5 million. For the right region and the right time, the multiple for the plumbing industry is 3.
Business valuation = EBITDA or SDE x Multiple.
In this example, $5 million (EBITDA) x 3 (multiple) = $15 million. The business is worth $15 million, and that would be a reasonable asking price.
Why Valuation Matters
Understanding Valuation
Real estate is a common example of valuation that people use in everyday life. Comps (the selling price of other homes nearby) determine property value.
If all comparable houses on Daisy Lane have sold for $300,000 in the past year, that number is a good estimate for price per square foot. This is a fair valuation because the data is recent.
One homeowner on Daisy Lane has spent a fortune upgrading the kitchen and backyard. With these add-ons, a $600,000 asking price for a house on Daisy Lane is still unreasonable because internal upgrades in a home don’t matter, what matters most are the comparables (comps) paid for other houses nearby.
Many businesses have acquired hundreds of awesome reviews or thousands of active followers on social media, but business valuation does not necessarily consider every aspect of a business that makes it unique.
Business valuation considers profits, assets, and industry multiples. Value is always determined by the buyer because an asset is only worth what someone is willing to pay.
Where is the range of fairness?
Disadvantages of Poor Valuation
An improper valuation is not fair to both parties. If the selling price is too low, the seller is not properly compensated for their hard work. If the selling price is too high, the investor cannot make a return on investment. SYE avoids these negative outcomes by creating win-win situations that address the needs of both parties.
Often, valuations that are too high or too low prevent a deal from happening before they even start. If a valuation is way too high, many investors will not even give the business a second look.
If the valuation is too low, this can also make investors warry. Just as in the housing market, an extremely low valuation is a red flag that makes buyers believe there is something wrong with the asset.
Low valuations can happen when a seller is very motivated. They could also signify a serious problem with the business. While a low valuation may not be the demise of a deal, it can cause the investor to ask serious questions.
Valuation assigns a fair value to a business using current data on profit and industry standards. Proper valuation is provable and fair to everyone.
Valuations that use common standards and proper multiples is a simple math equation. Either party can explain how they arrived at a certain valuation in a matter of minutes, and they can provide sources to support their view.
A Final Note
“I know behind every entrepreneur there’s a very loving, husband or wife, son or daughter, or friend that supported them. So, when I look at people selling their companies, I take all of that into consideration. I take into account the sleepless nights, the wins, the victories, and the entire journey of their business when I’m creating a valuation to give an offer.” says Christopher Wick.
Valuation Quotes
"Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation." - Warren Buffett
"Nothing turns off an investor more than when an entrepreneur comes in with a ridiculous valuation." - Kevin Harrington
"Selling, in particular, can be a challenge; many investors are tempted to become more optimistic when a security is performing well. This temptation must be resisted; tax considerations aside, when a security reaches full valuation, there is no longer a reason to own it." - Seth Klarman
More Resources
About Say Yes! Enterprises
Say Yes! Enterprises is an investment management company that acquires, builds, and sells companies that benefit shareholders, customers, team members and communities at large.
About Christopher Wick
Investor, 9X Award-Winning Entrepreneur, and 5X Best-Selling Author & Speaker
*Founder/Principal of businesses that have been featured by Huffington Post, ABC, NBC and Wall Street Select*
Christopher Wick is an award-winning entrepreneur who has built, bought and sold various companies relating to social media marketing, e-commerce, real estate, retail and investing.
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Say Yes! Enterprises is an investment management company that acquires, builds, and sells companies that benefit shareholders, customers, team members and communities at large.
Say Yes! Enterprises is an investment management company that acquires, builds, and sells companies that benefit shareholders, customers, team members and communities at large.