How to Value a Business: The Brutally Honest Guide to What Your Company is Really Worth

Figuring out how much your business is worth can be a daunting task. There are dozens of different valuation methods, each with its assumptions and limitations. And let’s be honest – most business owners have yet to learn what they’re doing regarding valuations. They just pick some arbitrary multiple of profits or revenue that sounds reasonable and hope for the best.

In this brutally honest guide, I will walk you through the key factors that drive business value. I’ll explain the most common valuation methodologies in plain English and when you should (and shouldn’t) use them. By the end, you’ll have a solid grasp of what your company is really worth – and what levers you can pull to increase that value over time.

So grab a stiff drink, and let’s get started. It ain’t going to be pretty. But let’s figure out How to value a business

The Three Pillars of Business Value

When it comes to valuing a business, three core pillars matter:

• Cash flow
• Risk
• Growth

These are the fundamental drivers of value. Master these three, and you’ll be ahead of most other business owners trying to value their company.

Cash Flow is King

The value of a business is based on its ability to generate cash. The more cash a business can produce, the more an investor will pay.

Earnings don’t mean jack. Accounting games can easily manipulate net income. The only thing that matters is cold, hard cash.

Specifically, you want to look at the business’s maintainable cash flow. It is the ongoing cash flow the business can generate after paying all expenses necessary to operate the business.

Maintainable cash flow excludes one-time revenues or expenses and accounts for necessary capital investments to generate cash in future years.

Risk Matters

The lower the risk in maintaining cash flows, the higher the valuation.

Factors that increase risk include:

• Reliance on a single customer, supplier, or employee
• Undifferentiated products with lots of competition
• Low barriers to entry into the industry

Factors that decrease risk include:

• Diversified customer base with recurring revenue
• Unique products protected by patents or trademarks
• High switching costs for customers

A predictable, recurring revenue stream will be valued much higher than a volatile, commodity business.

Growth Drives Value

The final pillar is growth potential. The faster a company can grow its cash flows, the higher its value. Imagine two companies, A and B. They both produce $1 million of maintainable cash flow today.

Company A is growing at 20% per year. Company B is stagnant with no growth.

Which would you pay more for? 

Obviously, company A has a much higher upside value from its growth.

High growth signals untapped potential and future cash flow expansion. Investors will pay up for growth.

Okay, now that we’ve covered the key drivers of value, let’s look at how actually to estimate what your business is worth…

How to Value a Business: The 4 Methods

There are four main methods used to value a private business:

• The Market Approach
• The Income Approach
• The Asset Approach
• The Venture Capital Method

Each has pros and cons for different situations. Here’s a quick overview:

The Market Approach

This method values your company based on multiples from recent transactions of similar businesses. For example, you can look at the sale price divided by EBITDA or revenue from other deals to benchmark your own multiple.

Pros:

• Based on actual market evidence, not estimates
• Simple to calculate

Cons:

• It is hard to find perfect “comparable” sales
• Market prices fluctuate over time

Best for: Mature businesses with several good comparable sales

The Income Approach

This method estimates value based on the future cash flow the business is expected to generate.

The maintainable cash flow is forecasted for future years and discounted back to today’s value using a required rate of return.

Common income approach methods include Discounted Cash Flow (DCF) analysis and the Multiple of Discretionary Earnings (SDE) technique.

Pros:

• Directly values future cash flow potential
• Allows factoring risk and growth into valuation

Cons:

• Depends heavily on cash flow projections
• Requires estimating discount rate/multiple

Best for: Asset-light businesses with stable cash flows

The Asset Approach

This method totals up all the business’s assets and subtracts its liabilities to derive value.

Assets may include real estate, inventory, equipment, and intangible assets like brands or patents.

Pros:

Simple balance sheet calculation

Cons:

• Doesn’t account for future earnings potential
• Many assets like brands are hard to value

Best for: Capital-intensive businesses like manufacturers

The Venture Capital Method

This approach values early-stage companies based on the expected future value at exit.

The potential exit proceeds in 3-7 years are estimated and discounted back to today’s value.

Pros:

• Matches valuation logic of VC investors
• Values growth potential directly

Cons:

• Highly speculative exit values
• Very sensitive to assumptions/projections

Best for: Pre-revenue or early-stage startups

Okay, let’s move on to some tips for applying these valuation methods…

5 Tips for Accurately Valuing Your Business

No matter what valuation approach you use, here are five tips to ensure you get an accurate business valuation:

Use Multiple Methods

Each valuation method has pros and cons. Get a range of values by using 2-3 different methods.

It will account for the limitations of any single approach.

Normalize Cash Flows

“Normalize” cash flows by removing one-time or non-recurring expenses or revenues.

You want to value based on maintainable cash flow in an average year.

Carefully Project Growth

Don’t be overly optimistic with growth projections. Use historical growth rates unless you have very concrete plans to accelerate growth.

Account for Risk

Apply a discount rate or lower multiple for higher risk levels in the business.

Be conservative – it is better to be pleasantly surprised than disappointed!

Get Professional Help

Consider hiring a professional business appraiser, especially for large or complex valuations.

It’s worth the investment to get an independent, expert valuation.

Okay, let’s move on to some common mistakes to avoid…

3 Common Business Valuation Mistakes

It’s easy to botch your business valuation if you need to know what you’re doing. Here are some big mistakes to avoid:

Using the Wrong Valuation Method

Different methods apply better to different businesses. Don’t just default to a multiple of EBITDA if your business doesn’t produce EBITDA!

Not Normalizing Cash Flows

One-time revenues, expenses, or owner’s compensation must be adjusted to reflect maintainable cash flow.

Failing to Account for Risk

All else equal, higher-risk businesses should have lower valuations. Pay attention to risk factors!

How Much is Your Business Worth?

Let’s do a quick case study to see how you can calculate business value in the real world.

Imagine you own a medical billing company with the following stats:

• Annual revenue of $2 million
• Annual EBITDA of $400,000
• Minimal capital expenditure requirements
• Steady 10% annual revenue growth over the last 5 years

You’re interested in selling in the next year or two. How much is your business worth?

Here’s how you can arrive at a valuation:

Market Approach

Lookup recent sales of similar medical billing firms. You find they sold for 3-5x annual revenue.

Your revenue multiple valuation range is, therefore:

• Low end: $2M * 3 = $6M
• High end: $2M * 5 = $10M

Income Approach

Forecast 10% growth for the next five years. Apply industry multiple of 4x EBITDA.

Discounted back at 25% required return gives a valuation of ~$7M.

Conclusion

Based on multiple approaches, your business is likely worth $7-8M as a reasonable estimate.

This case illustrates how using a blend of different methods can give you confidence in your valuation.

Frequently Asked Questions:

Key Takeaways

Here are the core lessons for accurately valuing your business:

• Cash flow, risk, and growth drive value
• Use multiple methods to triangulate on a valuation range
• Carefully project maintainable cash flows
• Apply lower multiples/discount rates for higher-risk
• Get help from a professional appraiser for large valuations

Business valuation is equal parts art and science. By understanding the key value drivers and avoiding common mistakes, you can land on a reasonable valuation range for your company.

What matters most isn’t the exact valuation number – it’s identifying the levers that will enhance your business value over time. Ultimately, you want to focus on boosting sustainable cash flows and reducing risk.

So be honest, avoid optimism bias, and make data-driven decisions to maximize your business value. Those are the keys to getting top dollar when it comes time to cash out!