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What Valuation Method Is Best for Your Online Business? Here’s How to Find Out
By Quiet Light
If you’re planning an exit, you may be wondering what valuation method is best for your online business. After all, there are several different ways to value a business. Given the importance of getting an accurate and thorough valuation, it is crucial to understand the most appropriate valuation method for your specific business.
In this article, we address several key elements about the business valuation process, including:
- The different approaches to valuing online businesses
- How to calculate online business value
- Whether or not you should use automated business valuation tools
“Given the importance of getting an accurate and thorough valuation, it is crucial to select the most appropriate valuation method for your business.”
Valuation Approaches for Online Businesses
If you have been looking into getting a valuation for your business, you have no doubt encountered the numerous different valuation methods used for calculating value. As a small business owner, this can be confusing. Which option is right for your business? How do you go about choosing?
Below, we will review some of the common ways you can value a business.
“There are many other factors besides total assets and liabilities that ultimately influence how much a person is willing to pay for your company.”
The book value of a business is fairly straightforward to calculate. Put simply, it is the company’s total assets minus the company’s total liabilities. Book value gets its name from the fact that accounting statements maintain accurate assessments of the company’s assets and liabilities. By looking at the financial statements, or books, one can easily determine a business’s book value.
In other words, book value is the total amount of value that a company’s shareholders could expect to receive if you were to liquidate the company. There are other situations where book value is a helpful metric for measuring the value of a company. For example, it is helpful when trying to determine if the stock of a company is overpriced or underpriced.
Since book value does not take into account factors beyond the assets and liabilities listed on the balance sheet, it is often lower than other methods of calculating value. As we will see, there are many other factors besides total assets and liabilities that ultimately influence how much a person is willing to pay for your company.
Market capitalization valuation method
Market capitalization is a very common valuation method for calculating the value of a business. Like book value, calculating value by market capitalization is a fairly straightforward process. The market capitalization value of a company is equal to the total value of a company’s outstanding stock shares.
Market capitalization value of a company = the number of outstanding shares x the current market value of a share.
When measured by market capitalization, the value of a company can vary widely due to rapidly changing public expectations about the company’s future performance. These changes in expectations raise or lower the stock price, thus influencing the overall value of the company.
Generally, you use market capitalization to determine the value of publicly traded companies. As such, it is not helpful when it comes to valuing sole proprietorships, LLCs, or other private company structures. This makes the market capitalization method of calculating business value useless for many online business owners.
“The market capitalization value of a company is equal to the total value of a company’s outstanding stock shares.”
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Times-revenue valuation method
The times-revenue method of calculating business value is another widely used business valuation method. According to the times-revenue method, the maximum value of a business is equal to the revenue multiplied by a number.
The exact number, or multiple, that the revenue is multiplied by varies from business to business. Additionally, the multiple varies from industry to industry. Revenue multiples can range from less than one on the low side to above two or three on the higher side.
However, the times-revenue valuation method is often not an exact estimate of the value of a business. Two companies that have similar revenue may have very different profit levels. The times-revenue method would not necessarily factor in this difference, and the true values of the companies would likely be quite different from each other.
Discounted cash flows
You use the discounted cash flow valuation method to evaluate the viability of potential investment options. Since purchasing a business represents an investment, the discounted cash flow method can be used to value a company.
Essentially, the discounted cash flow valuation method estimates the current value of a business, project, or investment based on the expected future cash flows of the venture. The future cash flow is discounted in order to factor in the time value of money.
Of course, the reliability of this valuation method depends on the accuracy with which future cash flows can be estimated. This is never guaranteed. As such, it’s easy to overestimate or underestimate business value, sometimes substantially.
Market value method
The market value method, or fair market value method, is a subjective estimation of the value of a business. With the market value method, you calculate the value by comparing it to other similar businesses that have sold very recently.
As you can imagine, you must have a large enough sample size of recent similar businesses sold within your niche in order to use the market value method. When this information is not publicly available, this can be a difficult condition to meet.
Even when you do have a sufficient number of similar businesses to compare yours to, this valuation method is still just an estimation of value at best. While two businesses may seem similar at first glance, there can be many hidden factors that would make one more valuable than the other.
Intangible assets, operational efficiency, and the quality of business relationships are just a few of the factors that could cause the value of two similar-seeming businesses to diverge.
The liquidation value of a business is a measure of the value the business would yield to its owners (or creditors) if it were to go out of business and have all of its assets sold.
While the liquidation value method is relevant in certain circumstances, it is not designed to estimate the value of a business that plans to operate long into the future. Given that, it is not a good option to use when estimating the value of your business in order to put it onto the market.
“The SDE multiple valuation method is often the preferred method of calculating the value of an online business.”
SDE multiple valuation method
With the SDE multiple method, SDE stands for seller’s discretionary earnings. SDE is similar to the profit of a business but has some crucial differences. We will explore these differences in more detail below.
As with the times-revenue method, the SDE multiple method multiplies the SDE by a number to arrive at the total value of the business.
Business value = SDE x the multiple.
However, since you use SDE instead of revenue, the estimated value is often much more precise than the revenue method. The multiple also varies from business to business and from industry to industry. We will explore what determines the multiple in more detail below.
Given these advantages, the SDE multiple valuation method is often the preferred method of calculating the value of an online business.
How to Calculate Online Business Value
Now that we have reviewed the various valuation methods of calculating business value, let’s take a closer look at the SDE multiple method. What is SDE? How is it calculated? And what determines the multiple for a given business?
Below, we will explore the answers to these questions. We will also discuss the factors that drive the underlying value of any online business.
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The seller’s discretionary earnings is a measure of the total financial benefit the business provides for its owner. In other words, the SDE captures the true money-generating capacity of the business.
While SDE is similar to profit, there are crucial differences. As we will see, these differences can dramatically alter the value of a given business. To calculate SDE, start with profit. Then, add back certain discretionary expenses. These expenses include:
- One-time investments
- Owner’s benefit
- Noncash expenses
- Unrelated expenses or income
This is not an exhaustive list. However, it is extremely important to add back all appropriate discretionary expenses to arrive at an accurate SDE figure.
Profit vs. SDE
Compared to profit, SDE more accurately represents the true income of the business that the owner benefits from. If an expense is incurred at the discretion of the owner, it is added back to the profit to be included in SDE.
While two companies may have similar profits, their SDE could be quite different. As such, SDE does a better job than profit of comparing companies to each other.
For example, let’s say there are two companies, company A and company B, each with an income of $100,000 per year. To keep things simple, let’s assume company A has no discretionary expenses. Thus, their SDE is also $100,000.
The owner of company B voluntarily incurs $15,000 of travel expenses over the same period. These expenses are discretionary because the owner did not need to incur them as part of the necessary operations of the business. In order to calculate SDE, you add back this $15,000 to profit, to arrive at a figure of $115,000.
Right off the bat, you can see that company B will likely be more valuable than company A, all other things being equal. Let’s also assume, however, that each company has a multiple of 2.5 (more on multiple values below).
In this scenario, company A has a value of $250,000 ($100,000 x 2.5). Company B, on the other hand, would have a value of $287,000 ($115,000 x 2.5). By adding back the discretionary travel expenses to arrive at SDE, company B automatically adds $37,000 of value.
“Compared to profit, SDE more accurately represents the true income of the business that the owner benefits from.”
On the surface, the multiple is just a number. As we have mentioned, however, multiples vary from company to company. This means there may be two companies with identical financial metrics but widely different values. How can that be possible?
In essence, the multiple goes beyond the SDE to capture the underlying tangible and intangible aspects of value for any given company. Ultimately, the value of the multiple a company receives is based on the amount of money a buyer is willing to pay for it.
There are many factors that influence how high or low a multiple a company is likely to get. For the sake of discussion, it is helpful to group these factors into several main categories. Taken together, these are the Four Pillars of Value. They include:
The way that a company stacks up on all of these metrics will directly influence its multiple.
“In essence, the multiple goes beyond the SDE to capture the underlying tangible and intangible aspects of value for any given company.”
Strong current and historic growth for a company signals to interested buyers they can expect a healthy return on their investment if they buy the company; the opposite is also true. As you can imagine, growth is an important factor when calculating value.
Company growth aside, buyers will also look to see if the company’s industry as a whole is growing or declining. Industry-wide growth bodes well for the future prospects of the company.
Lastly, serious buyers want to see clear opportunities for future growth. If you can show them a few untapped areas of growth within your company, you can help drive up the multiple (and value) of your business.
“Industry-wide growth bodes well for the future prospects of the company.”
While growth is positive, risk is negative. All other things being equal, the riskier a business is, the less attractive it will be to a potential buyer. This is because they want a high level of confidence they will receive a future payout for their investment.
There are many things that can create or minimize risk. For starters, the longer a company has been around, the less risky it is estimated to be. In addition, the revenue source (or sources) that the company enjoys also plays a role.
Let’s say there are two similar companies. One is a long-established SaaS business that benefits from healthy recurring revenue derived from several different subscription products. The other is a new company that relies on a single Amazon product for the entirety of its revenue.
“The more diversity is built into the success of a company, the less risky it will be.”
In this scenario, which one do you think would be riskier? Most buyers would say the second company. For one, the recurring revenue model is often perceived to be more stable than other models.
In addition, the first company has a diversity of products, while the second is solely reliant on a single product. The more diversity is built into the success of a company, the less risky it will be.
“All other things being equal, the riskier a business is, the less attractive it will be to interested buyers.”
In order for your company to have value to a new owner, it must be able to be transferred without the business being negatively impacted. The ease with which a business can be moved from one owner to another is referred to as transferability.
There are many factors that make a business more or less transferable. Building out a team to run your business and automating processes will serve to increase the transferability of your company.
On the other hand, if your personality, image, or likeness is intimately linked to your business, it would present problems for a new owner. By taking the time to remove yourself from your business, you will increase the transferability, and value, of your online business.
Maintaining clear documentation is also crucial for driving up the value of your business. Financial records measuring revenue, costs, tangible assets, net profit, and other metrics are a must. In addition, it is important to create and document clear standard operating procedures for your business operations.
To sum it up in a quick example, imagine two companies with identical SDEs. One is growing quickly, has minimal risk, is easily transferable, and has impeccable documentation. The other is experiencing declining revenue, incurs significant risk, and is not easily transferable—and their documentation is a mess.
Which company do you think would be more sought after by interested buyers? In all likelihood, you would be willing to pay somewhat (perhaps significantly) more for the first company than the second. This preference is captured by the difference in the company’s multiples.
“Many entrepreneurs skip online business valuation tools in favor of getting a professional valuation.”
Do Automated Business Valuation Tools Work?
As a business owner, you may have encountered online business valuation tools. While an automated valuation model may be tempting to use, it is important to understand the pros and cons before using one to value your business.
The main draw to using a business valuation tool is ease of use. Online business valuation tools make it simple and quick to assign a numeric value to your business. Simply input some information, and the calculator spits out a number.
However, this number is often not entirely accurate. As we have seen, there are many tangible and intangible factors that go into determining the value of your business. Even calculating your SDE may not be easy, depending on your knowledge level.
Given the importance of creating an accurate valuation, it pays to get it right. For this reason, many entrepreneurs skip online business valuation tools in favor of getting a professional valuation.
By finding an experienced business Advisor (also called a business broker), you can work to create an accurate valuation for your company. This will help you plan for the future, optimize your company, and ultimately receive a higher payout when you do decide it is time to sell your business.
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