How to Value a Business Based on Revenue
There are several reasons an entrepreneur may seek to learn how to value a small business and multiple ways to determine value. Obtaining a business valuation report is valuable when planning for future growth, understanding the current state of your business, or when you make plans for selling your business. A company valuation based on revenue is one way to evaluate the value of a business that we will discuss in detail here. To get started on valuing your business, click here for access to Coachwell’s free Estimate of Value tool from our Value Builder Software.
How to Value a Business Based on Revenue
To understand how to value a business based on revenue, first be clear on the differences between revenue and profit. Revenue is the cash flow obtained by a company through the sale of goods and services to its customers. Profit is what remains after deducting expenses and taxes from revenue. A valuation based on revenue looks at the past revenue generated by a business over time while predicting the potential for revenue growth.
Revenue growth predictions are based on industry standards and depend on the type of business. The most accurate business valuations using revenue are of companies with consistent sources of recurrent revenue year to year and often are less mature or established in an industry. A business coach or advisor can help small business owners decide if valuing their business based on revenue is the best approach for an accurate valuation, particularly when getting ready to sell. Business coaches who also have experience putting together valuations can help with steps to improve the business revenue and overall profitability.
Start by Understanding How to Value a Small Business Overall
When approaching business valuation, business owners must start by gathering their financial reports, getting an accurate list of assets and liabilities, and obtaining data on industry trends.
Determining the value of a business is not as simple as looking at the numbers. Revenue, expenses, assets, and liabilities included in financial reports are helpful tools in analyzing the health and value of a small business; however, there are other factors to consider as well. Simple valuations that account for profit and the balance between assets and liabilities can miss out on a more complete picture of a company's potential for future growth and profit. The overall value of a business may require a more specific approach. Depending on the industry, the health of the company, and goals in mind, a small business owner may choose to value their business based on revenue over profit, etc. That is why different valuation methods exist; to address these differences and get an accurate picture of a business value.
Conversely, with so many valuation methods, a business owner must choose the right one to accurately value their business, depending on the purpose it is meant to serve. Determining the best approach can be a challenge for a business owner whose focus lies in the everyday operations of their business. Working with a coach who understands their business and the different valuation methods in detail can assist in the process. Meanwhile, the owner can focus their efforts on increasing the value of their business through increasing revenue, maximizing assets, and developing their key employees.
To understand how to value a small business overall, having a general understanding of some standard valuation methods is helpful. Some frequently used valuation methods include discounted cash flows, book value, EBITDA (earnings before interest, taxes, depreciation, and amortization), enterprise value, and times-revenue approaches.
Discounted cash flow analysis looks at the projected future cash flow based on the initial investment, then determines the current value using a discount rate. The DCF valuation method can provide information on the investment value over time. The limitation of this method is primarily the variability of cash flow over time.
Book value is one of the simplest methods of valuing a business. Assets minus liabilities, excluding intangible assets, reveal the business equity. Although this is a very straightforward and easy-to-understand valuation method, it does not account for intangible assets or growth potential.
EBITDA is a measure used to determine the overall profitability of a business while excluding costs. The EBITDA takes the net profit in financial reports and re-adds the interest, taxes, depreciation, and amortization. This method is valuable when comparing similar companies, but its limitations lie in the lack of expenses accounted for when looking at the overall value of a company.
Enterprise value is often considered one of the most comprehensive and complete valuation methods. The enterprise value is calculated using the market capitalization of a business and includes any debt and existing cash in financial reports. Market capitalization is analyzed differently depending on whether or not the company is publicly-traded. The enterprise value can also be used in other ratios to determine company performance. Limitations of the enterprise value method revolve around the inclusion of debt in calculations. A company with a high amount of debt invested in the necessities for operating may not be served best using this valuation method.
The times-revenue approach based on a multiple of revenue is what we will discuss in more detail. In short, the times-revenue method analyzes the worth of a business based on historical revenue data, times a multiple based on the industry in which it operates.
There are, of course, more possible methods not listed here. Regardless of the valuation method chosen, working with a business coach will ensure the accuracy of calculations and guide how to use the valuation in negotiations or in driving future growth.
Putting Together a Valuation Based on Revenue
There is more than one method to value a company based on revenue data. Each strategy will produce a different result depending on the calculations used. A revenue valuation using the revenue multiple method, also known as the times-revenue approach, is one method commonly used.
The primary purpose of finding the value of a business based on revenue using the times-revenue approach is to determine the maximum potential value of a business. Because of this, the times-revenue method is often a preferred strategy when valuing a company for the purpose of selling.
To calculate the value of a business using the times-revenue method a multiple is applied to revenue data from a period. The time period used in this calculation is typically the previous 12 months. The multiple varies depending on the industry involved and the current economic environment. Working with a business broker experienced in selling businesses can help nail down the correct multiple for an accurate picture of the company. The more potential for growth and the friendlier the economic environment, the higher the multiple used. A lower multiple is applied in slower-growing industries when using the times-revenue approach. Companies with higher potential for growth can benefit most from a valuation based on revenue when using the times-revenue method.
Opposingly, a business owner can use the selling price of a business to determine the multiple of revenue by dividing the selling price by the previous 12 months' incoming cash flow. Calculating the revenue multiple in this way can be helpful to other businesses in an industry to analyze growth potential. It can also be a tool for business brokers to choose the right multiple when helping an owner value their business for sale.
Common Misunderstandings with Small Business Valuations
Especially when preparing to sell or buy a company, there are some common misunderstandings to avoid regarding small business valuations. Here are a few to consider:
Not all comparisons are equal. Even when using the same valuation method, comparing two companies in different industries does not guarantee an accurate comparison between the value of each. Other economic factors, particularly the industry growth involved, come into play.
Over or under-estimating value due to flawed or manipulated data is a concern. In particular, when getting ready to purchase a company, make sure that you take a closer look at the figures used to determine value.
The value of a business is not set in stone. Valuations are meant to provide a general idea of the value of a company based on multiple factors. But because different valuation methods will come up with various figures, valuations are only meant to supply a starting point for negotiations when buying and selling a business or preparing for other transitions.
Having unrealistic expectations about future growth can lead to inaccurate valuations. Setting realistic expectations is why working with an experienced business coach or broker is helpful to pinpoint the correct multiple.
Profit differs from revenue, not all debt is bad debt, and liabilities can be necessary for operations. These are also things to consider when putting together a valuation. Although debt, liabilities, and expenses may traditionally sound 'bad,' when assets are managed effectively, it becomes clear that the negatives on a balance sheet can be assets in disguise.
When valuing a business based on revenue, a low multiple is not necessarily a bad thing. It is more important to value the company accurately and choose the most precise multiple. When putting together a company valuation based on revenue, the best multiple is whatever provides the most accurate projection based on industry growth and economic demands. Small business owners can, however, make strategic efforts to improve their multiple.
When a Company Valuation Based on Revenue Isn’t Enough
Revenue does not equal profit. When putting together a valuation, it is necessary to consider multiple factors that may impact overall profitability. Short and long-term debt, overhead expenses, tax, depreciation, amortization, etc., are all variables that may be relevant and necessary to consider when putting together a valuation.
Increasing revenue does not always transfer to increasing profit if expenses are also growing. A different method may be necessary to determine an accurate company valuation.
Wondering What Your Company is Worth?
As a business owner, keeping an accurate estimation of your business worth in mind can be helpful for many reasons. Awareness of your business worth allows you to plan for growth, prepare for transitions, and track progress toward your business and personal goals.
Coachwell's team of executive business coaches and brokers will help you pick the best valuation method for your company. Whether preparing your company to scale or getting ready to sell and transition away from your business, Coachwell has the experience and expertise to assist in your goals. Gain insight into the health and growth potential of your business by contacting Coachwell today for a personalized consultation.
