When you're running a business day to day, it's easy to focus only on this month's numbers and lose sight of the bigger question: what is the business actually worth?
That question matters whether you're gearing up for a sale in the next few years or simply want to know you're building something valuable over time.
Business valuation isn't guesswork and it isn't just a multiple of earnings pulled from thin air. It comes down to a structured look at 4 key areas:
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The external market you operate in
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The underlying health of the business
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The earnings it can be expected to sustain
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What similar businesses are actually selling for.
Below we break down each of these 4 drivers and then work through a real-world example so you can see how they come together to produce a valuation range for a business of your own.
Key lessons
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Business value isn't only about selling. Understanding your value helps you track returns and build wealth over time, the same way you'd track yield and capital growth on a property.
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Four factors drive value: external market conditions, business health, future maintainable earnings and market comparables.
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Earnings alone don't set your price. A multiple of your earnings does, and that multiple moves up or down based on risk.
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Concentration is a red flag. Relying on one client, one supplier or one owner for most of your revenue or relationships lowers what a buyer will pay.
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Know your range before you need it. Calculating a realistic value now, rather than during a sale, gives you time to fix weak spots and lift your multiple.
The 4 drivers of business value
If you're looking to value your business, there are 4 key elements to focus on.
It's worth noting that valuation isn't just an issue for someone wanting to sell. You're making an investment in a business and taking a risk.
You want to know the return and you want to know you're nurturing and building value over time. It's somewhat like a residential or commercial property: you look at it from 2 angles, the yield it generates and its capital growth.
Business works in a similar way, however it more closely considers investment and return together. A good business is one that efficiently uses assets to drive sustainable earnings and so, unlike real estate, capital or asset value growth in a business – without earnings improvements – doesn’t always mean a higher value. Therefore, in a business the key is the sustainability of the return on your investment.
1. External market, competitive trends and issues
Take a good hard look at what's going on in your sector. Who are the movers and shakers? Is regulation and compliance a factor and is it affecting the returns in your sector? Are there disruptors, whether from technology or new business models, changing how you operate?
Think of the classic video store example. Once a dime a dozen, video stores disappeared almost overnight once new technology changed how people consumed media. That's how a single external factor can reshape an entire industry.
The goal here is to work out whether the forward outlook for your sector is positive, neutral or negative.
2. Business health factors
This is where you act like a GP giving your business a health check. Some key things to look at:
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Your team. How strong are their skills and capabilities and how well does the culture support your business model?
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Systems, processes and technology. Are there gaps that better technology could close? Do your systems and reporting give you regular updates and benchmarks on performance?
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Supplier relationships. Do you rely on more than one supplier? If you depend heavily on one, that's a concentration risk if they went out of business.
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Client or customer portfolio. Is your customer base concentrated in a few clients, a single geography or one sector, or is it evenly spread with little concentration risk?
3. Future maintainable earnings
This is the financial core of a valuation. Future maintainable earnings is a theoretical measure of what the business will earn over the next 12 months given its sustainable, regular performance and factoring in the last few years of results.
The standard proxy is EBITDA (earnings before interest, tax, depreciation and amortization), calculated from your profit and loss statement. From there you adjust for anything abnormal. A one-off legal cost, for instance, gets added back because it's not a recurring expense. If you're an owner taking dividends rather than a wage, a market-appropriate wage gets factored in instead, so the final figure reflects the business fully staffed and fully costed.
A common approach is to look at earnings over the last 3 years and weight each year based on whether the outlook is improving, steady or declining.
4. Market comparables
Market comparables reflect what investors and other businesses are actually paying for similar businesses. This means keeping an ear to the ground in your industry and talking to advisers about recent sale prices.
Often the key figure is a multiple of earnings. A pharmacy, for example, might sell for 5 to 7 times earnings. If your future maintainable earnings are $500,000 and comparable businesses sell for 5 to 7 times earnings, your enterprise value range is $2.5 million to $3.5 million.
Enterprise value differs from equity value. Enterprise value is the going concern value of the business: the assets generating the return, the working capital and any goodwill attached to it.
A real-world example
Consider an engineering business that's been running for 30 years with one owner heavily involved day to day, about 25 staff and $10 million in turnover. Turnover has stayed fairly static over 3 years and bottom-line profit has ranged from $500,000 to $1 million.
External market: Several new, aggressive competitors have entered the space and are bidding hard on margin. There's also a shortage of skilled engineering staff and rising safety regulations that add to compliance and training costs.
Business health: Three long-standing clients provide strong repeat business, but they also make up 60% of turnover, which is a concentration risk. On top of that, the owner holds most of the client relationships and does most of the business development. That reputation is valuable, but it also creates owner risk: if something happened to that person, earnings could suffer.
Future maintainable earnings: Earnings have swung between $500,000 and $1 million over 3 years due to project timing. Looking at the current pipeline, future maintainable earnings land somewhere between $800,000 and $1 million, so for this example we'll use $1 million.
Market comparables: Similar businesses in this sector have sold for 3 to 5 times future maintainable earnings, putting the raw range at $3 million to $5 million.
That's a wide range, and this is where the health check comes back in. Because of the client concentration and owner risk identified earlier, this business is more likely to sell at 3 to 4 times earnings rather than 5, since those risks make it less attractive to a buyer taking it over.
The takeaway
All 4 elements need to be weighed together to land on a realistic value: the external market, business health, future maintainable earnings and market comparables.
Whether or not you're planning to sell, understanding these drivers gives you a genuine management tool to improve performance and build value over time.
Free resources
The JPAbusiness team has created a number of free resources to help our clients and subscribers understand the business valuation process:
- How to assess business value ebook
- Strategic value checklist
- How to calculate Business Maintainable Earnings infographic
- What is the difference between a valuation and a market appraisal? video
Take a look at our online Resource Library for more resources for business operators, buyers and sellers.
If would like assistance to determine future maintainable earnings or assess business value – whether you are buying, selling or looking to grow the value of your business – contact the team at JPAbusiness for a confidential, obligation-free discussion.
