Value Your Business (Warning: Math Enclosed)

If you own something valuable, you'll probably be interested in knowing its value at one time or another. Oddly enough, though, many entrepreneurs don't understand how to accurately value what is likely their most important "possession": a business. We're here to help.

Let's first eliminate a few misconceptions about exactly how to value a company:

  1. The value isn't equivalent to the firm's assets. Assets held on the balance sheet will help you determine the book value of the business but that is merely an accounting matter.
  2. The value isn't equivalent to the firm's assets less any liabilities. Again, that would be part of the book value equation (assets minus intangibles minus liabilities). Businesses rarely sell for book value. Don't sell yours so cheaply either.
  3. The value isn't equivalent to a sum of the firm's future accounting profits. Earnings reported on the income statement are a poor performance measure for all but the simplest firms.

How, then, do you value a business? You use the formula below...

where n is the number of periods until infinity,

CF is a specific cash flow,

t is an explicit period of time,

and r is the discount rate (typically the cost of capital)

Our math essentially states that you should value a business as the present value of the sum of all of its future cash flows. (Click here to better understand the present value concept.) This same formula applies to any asset, whether a stock, a parcel of land or a piece of art. Valuation is a universal concept with a rather intuitive foundation: You would rather have cash today than tomorrow, and you don't care about anything except for actual cash. Accounting profits regularly differ from cash flow, so we can't use earnings in the valuation itself. (Depreciation of an asset, for example, reduces profit but not cash flow.)

If you feel comfortable forecasting your firm's future cash flows, then the only remaining challenge is to determine your company's discount rate. (See the formula above to understand why you need this rate.) Calculating the discount rate for a small business is actually more challenging than it is for a publicly-traded firm like Apple. Why? Almost no entrepreneur can tell you his/her cost of capital.

Let's frame the question differently: How much are you paying for money to fund your business? For simplicity's sake, assume that you fund 30% of the business with debt and the remaining capital comes from your own savings. The cost of the debt equals its interest rate, 8% for our example. What about the cost of your own investment? Just insert the rate of return you need to earn each year to be willing to keep the business open. Here, we'll assume 10% is your requirement. To determine the discount rate, then, use the following formula:

where r is the discount rate,

wd is the weight of debt in the capital structure,

id is the interest rate of debt,

we is the weight of equity in the capital structure,

and ie is the required rate of return on equity

While the examples above are simplified and real businesses frequently require significantly more detailed valuations, we've outlined the essential quantitative and conceptual framework. Forward View doesn't recommend developing any valuation unless you're comfortable with Excel. You don't want to attempt the math on a calculator. Trust us. If the computations just make your head hurt, contact Forward View. No valuation project is too complex for our team. We regularly evaluate multi-billion-dollar global corporations for our equity research service, so we understand how to manage complicated requests. Don't hesitate to request assistance.

Nathan Yates

Nathan Yates has been fascinated by technology and finance since he was young. He was the kid devouring the business section of the newspaper (remember those?) while others read everything else. Nathan believes that the American economy is built from the bottom-up, meaning that small businesses and local nonprofits are the foundation of our nation's success. These organizations are the lifeblood of towns and cities across the U.S. Unfortunately, most consulting firms overlook companies or organizations that don't have eight-figure budgets. Nathan thought Forward View Consulting should be different. And we are. As Lead Consultant, Nathan works with each client to deliver only the best financial and/or website development services. Nathan's years of web design experience and his business degrees ensure that professional expertise is brought to each project. Our network of contacts can offer additional specialized guidance if needed. Before creating Forward View Consulting, Nathan worked for an independent equity research firm as a Research Associate covering the industrial and energy sectors. This work involved preparing quarterly 15-40 page reports on multi-billion dollar corporations along with timely analysis of M&A activity and industry-wide news. He also managed research distribution and the company's online presence. Nathan also spent a summer serving as a local financial adviser's Research Intern. Nathan earned a Bachelor's degree in Economics and Finance from Southern New Hampshire University, graduating summa cum laude. He then earned a Master's degree in Finance from Southern New Hampshire University, where he was named the Outstanding Student in his particular concentration. Now, Nathan is an adjunct professor teaching economics and finance for his alma mater. In his spare time, Nathan enjoys fishing, reading, time with family and serving as a volunteer webmaster for the Clintwood United Methodist Church.