Valuing a business is a critical task for owner-managed businesses, particularly when it comes to selling, merging, or raising capital. Whether you’re preparing for a transition or simply seeking to understand your business's worth, various valuation methods can be used. Each method has unique applications depending on the business’s size, industry, and financial situation. In this blog, we explore key business valuation methods and how they apply to owner-managed businesses in Canada.
1. Income-Based Approach
The income-based approach focuses on a business’s ability to generate future income. It is particularly well-suited for service-based businesses or those with consistent revenue streams. A central concept in this approach is normalized earnings, which adjust financials to remove irregularities and present a true reflection of the business's sustainable profit.
a. Capitalization of Earnings
The Capitalization of Earnings method calculates the business’s value by applying a capitalization rate to its earnings. However, to get a realistic value, it’s important to use normalized earnings. Normalized earnings reflect the business’s true ongoing profitability by adjusting for unusual or non-recurring items.
For example, in an owner-managed business, personal expenses or non-business-related benefits may be run through the company. These expenses, along with abnormally high owner compensation, are adjusted to align with industry norms. By doing this, the earnings figure better represents the business’s actual financial performance, ensuring a more accurate valuation.
For instance, if an owner-managed landscaping company typically shows $100,000 in net earnings but includes a large one-time expense like a legal settlement, normalizing the earnings would remove that expense. This gives a more accurate representation of the company's real profitability and, consequently, a more precise business valuation.
b. Discounted Cash Flow (DCF)
The Discounted Cash Flow (DCF) method estimates the present value of projected future cash flows. Like the Capitalization of Earnings method, DCF calculations often begin with normalized earnings to project a realistic and sustainable income stream.
For businesses experiencing temporary disruptions or irregular costs, such as a tech start-up investing heavily in research or infrastructure, normalizing the earnings helps project future profitability more accurately. DCF is ideal for businesses expecting growth or fluctuations in revenue over time. It helps identify what a buyer would be willing to pay today based on the business’s future earnings potential.
2. Market-Based Approach
The market-based approach compares your business to similar businesses that have been sold, using those sale prices as benchmarks for valuation. This is a straightforward method for owner-managed businesses when enough comparable data is available.
a. Comparable Company Analysis (CCA)
In this method, the business is valued by comparing it to similar companies that have been sold recently. For example, if other construction firms of similar size in the same region sold for three times their annual revenue, the owner of a similar business could apply that multiple to estimate the value of their business.
This method is widely used in industries where comparable sales data is readily available, such as retail or manufacturing.
b. Precedent Transactions
Precedent Transactions focuses on actual transactions of similar businesses in the same industry. For example, if a retail business in a similar market sold for five times its EBITDA, another retail business in that market could use the same multiple as a basis for its valuation. This approach works well when there are reliable and recent transactions to use as a comparison.
3. Asset-Based Approach
The asset-based approach values a business based on its assets, minus any liabilities. This approach is particularly useful for businesses with significant tangible assets, such as manufacturing companies, real estate firms, or businesses in industries like construction.
a. Adjusted Net Asset Method
The Adjusted Net Asset Method calculates a business's value by adjusting the fair market value of its assets and subtracting liabilities. For instance, an owner-managed trucking company with valuable trucks and equipment may determine its value based on the adjusted worth of those assets, reflecting what they could realistically be sold for.
b. Liquidation Value
In cases where a business is winding down or being sold for parts, the Liquidation Value method is used to determine what the business is worth if all its assets were sold off and liabilities paid. This is often used as a last-resort valuation method when the business is not expected to continue as a going concern.
4. Hybrid Approaches
In many cases, a combination of these methods may provide the most accurate valuation. For instance, a hotel business might use the income-based approach to assess ongoing earnings potential while also factoring in the significant asset value of the hotel property under the asset-based approach. Combining methods ensures that all aspects of the business’s financial and operational profile are considered.
Normalized Earnings: A Key Factor for Owner-Managed Businesses
For owner-managed businesses, normalized earnings play a critical role in the valuation process. In many small businesses, the owner’s personal expenses or discretionary spending may be run through the business. These costs can distort the company’s profitability if not adjusted for in the valuation process.
Common adjustments include:
- Owner’s Compensation: Adjusting owner salaries to reflect market rates for the same position.
- Non-Recurring Expenses: Removing one-time costs such as large legal fees or special projects that won’t affect the business going forward.
- Family Salaries: If family members are paid above-market rates or are not actively involved in the business, adjusting these salaries can help reflect the true profitability.
- Personal Expenses: Excluding personal expenses that are run through the business, such as personal vehicle costs or non-business travel.
By normalizing earnings, the valuation process reflects the actual operational health of the business, giving buyers and investors a more accurate picture of the company’s potential.
Conclusion
Selecting the right business valuation method is crucial for owner-managed businesses. Each method has its strengths, and the best choice depends on factors such as the industry, the business’s assets, and its earnings profile. Normalizing earnings is particularly important for smaller businesses, where personal and business expenses often overlap. Consulting with professionals like accountants or business appraisers ensures that the valuation process accurately reflects the true value of the business.
Whether you’re planning to sell, raise capital, or simply want to understand your business’s worth, these valuation methods provide valuable insights into how much your business is truly worth in today’s market.
