If you are thinking of buying or selling a small business, one of the most important questions you need to answer is: how much is the business worth? Valuing a small business is not an exact science, but there are some common methods and factors that can help you get a reasonable estimate.
One of the most widely used methods to value a small business is based on the seller’s discretionary earnings (SDE). SDE is the net profit of the business before taxes, interest, depreciation, amortization, and the owner’s salary and benefits. SDE reflects the true earning potential of the business for a new owner.
To calculate the value of a small business using the SDE method, you need to multiply the SDE by an industry-specific multiple. The multiple ranges from 1 to 4, depending on various factors such as the size, growth, profitability, risk, and competitive advantage of the business. For example, a small business with an SDE of $100,000 and a multiple of 3.5 would be worth $350,000.
Another method to value a small business is based on the discounted cash flow (DCF) analysis. DCF is the present value of the future cash flows that the business is expected to generate. To calculate the DCF value of a small business, you need to project the cash flows for a certain period (usually 5 to 10 years), and then discount them by a rate that reflects the risk and return of investing in the business. The discount rate is usually based on the weighted average cost of capital (WACC) of the business.
For example, a small business that is expected to generate $50,000 in cash flow per year for the next 10 years, and has a WACC of 10%, would have a DCF value of $307,000.
However, both SDE and DCF methods have some limitations and assumptions that may not reflect the reality of every small business. For instance, SDE does not account for capital expenditures or working capital needs, and DCF relies on uncertain projections and discount rates. Therefore, it is advisable to use more than one method to cross-check your valuation results.
Moreover, you should also consider other factors that can influence the value of a small business, such as:
- The assets and liabilities of the business: The net worth of the business (assets minus liabilities) can affect its value, especially if it has valuable tangible assets such as real estate, equipment, or inventory, or intangible assets such as patents, trademarks, or customer relationships.
- The market conditions and trends: The demand and supply for businesses in your industry and location can affect the value of your business. For example, if your industry is growing fast or has high barriers to entry, your business may be worth more than if it is declining or saturated.
- The strategic fit and synergies: The value of your business may also depend on who is buying or selling it. For example, if your business has a unique niche or competitive advantage that complements another business’s strengths or weaknesses, it may be worth more than if it is sold to a generic buyer.
If you need professional help to determine the value of your small business, you can contact Mendham Advisors. Mendham Advisors can help you determine a fair value for your small business, not only looking at past performance and current financials but also understanding strategic positioning, market volatility and future potential.
