What’s My Business Worth? – Part 1
I have been studying for my MQE the past few weeks (final exam that gives you your CBV letters in Canada – Chartered Business Valuator) and thought I would go over how most companies are valued based on a Capitalized Cash Flow basis. This approach is considered a “going-concern” approach as the business is expected to continue into the future (vs. a liquidation approach where the business is not expected to continue into the future).
A business valuation is not just done when you are looking to sell your business, but it is also done for certain tax reorganizations, estate freezes, shareholder agreement values, and many more.
Most business owners should know the approximate value of their business as one of the questions I have gotten before is “how exactly do you value my business”? Just to be clear this is only one method of quite a few but it is one of the most used methods. Let’s dive in.
Step 1: Calculate EBITDA
Your first thing to do will be to start at a company’s net income and add back taxes, interest and your depreciation for the year. This will calculate the company’s EBITDA (Earnings before interest, tax and depreciation/amortization). This number is essentially your company’s cash flow for the year without considering other factors. Do this for the prior 3-5 years to give a better picture of your business.
Step 2: Normalize Expenses and Revenues
Normalize your company’s expenses and revenues in each year. Certain adjustments to be made can be: a) non-recurring revenues/expenses like a one-time project that bumped your revenue up a lot in a year or a legal fee that will not be continuing on a go-forward basis, b) Revenue/expenses that are not relevant to the business- these can be when the company pays for owner golf fees, large salaries that aren’t at fair market value, or life insurance for the owner that is not necessary to the business.
Step 3: Deduct Income Taxes
This step is easy as once you total your normalized EBITDA for the year, you then multiply your tax rate by the EBITDA and subtract these taxes to give you your after-tax maintainable cash flow.
Step 4: Deduct Sustaining Capital Reinvestment and Working Capital
This one’s a bit of a mouthful. However, it is really simple. The sustaining capital reinvestment is the dollars spent each year that would allow you to produce your current cash flow. If you have a manufacturing plant that just needs regular equipment fixtures/upgrades each year in order to keep the business running, that would be your number (you would also reduce that amount by the tax shield this expenditure provides as it is added to a UCC account but I will leave that out to keep it simple).
You’re also going to have to deduct any growth in working capital as having your money tied up in inventory, accounts receivables and payables affects your cash flow.
Step 5: Multiply by Multiplier
Once all of the above is complete, you will multiply the number by your capitalization rate (cash flow multiple) to give you a capitalized value of these cash flows. The capitalization rate is derived from a bunch of different rates but that is a topic for another post.
Step 6: Determine your Enterprise Value
You have your capitalized cash flows but now you have to add the present value of future tax savings on the company’s current UCC (undepreciated capital cost). The tax shield formula can be complex and I won’t post it here as eyes might already be glazing over. But once you have the present value of the UCC amount, it is added to your capitalized cash flows to give you your enterprise value. The enterprise value is the total value of the equity and debt in the business.
Step 7: Redundant Assets and Interest-bearing Debt
The final step in calculating your business’ value is by adding any redundant asset in the business or subtracting any interest bearing-debt from the enterprise value. A redundant asset is an asset that is not used in the business operations like excess cash, marketable securities or land. Interest-bearing debt is what it sounds like, loans from banks or lines of credit. Once these amounts are added or subtracted from enterprise value, you have the value of the business.
Final Thoughts
This is a brief summary of how to get a rough idea of what your business is worth. There are other nuances that go into the calculation like how to treat preferred stock, calculation of the proper multiple/capitalization rate, non-capital losses, potential growth rate of the business, etc. Hopefully after reading this you have a better idea of what your business is worth.
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