Valuation is an important part of any business. This might be obvious for website flipping or models where a business sale is the main goal, but it’s also true even if the main goal isn’t a business sale.
Proper valuation of a business can affect the ability to get outside funding or investment, to show progress from your work, and provide a perspective on how the business is really doing and what it’s worth.
Understanding how to value a business based on profit is crucial to the long-term successful management of your business.
Why Value The Business?
Having an idea of how much a business is worth is always a good idea. Beyond that, there are three major reasons why knowing how to value a business is important.
To Buy or Sell a Business
The profit-based valuation is going to be the largest single factor when it comes to the price of buying or selling a business. While other factors come in during negotiation the starting base number will come from the standard profit valuation.
This makes accurate valuation crucial to understand whether a deal is a good one or if the asking price is out of line with what should be expected for the business.
To Create an Internal Market For Shares
A good business valuation can set the stage for creating shares of the business. This gives some degree of valuation for private stock worth, creates demand for those in the business ownership structure, and even gives a possible idea of what to expect with a stock release if the business goes from private to public.
To Motivate Management
Motivating management can be another excellent benefit of sharing the profit-based valuation of a business. Good numbers often translate to job security, possible bonuses, and a better position to gain raises in the future.
Even a weaker valuation may motivate management to work harder to shape up things to get better numbers and the previously mentioned security, bonuses, or raises for putting the company on solid ground.
Types of Business Valuations
There are multiple methods that can be used for valuing a business. The following are some of the most common that business owners and investors need to be familiar with.
Earnings Multiple Method
The earnings multiple method is one of the most commonly used business valuation methods and one that most online business owners and investors will have at least some experience with.
This method involves taking multiples of the business’s average monthly or yearly earnings, depending on the business type.
Where To Get The Profit Multiple Data?
The profit multiple data is going to come from whatever tracking is set up for all income and profits. For most content based sites that will involve adding together display ad revenue plus affiliate commission revenue. For other business models the data might be collected quarterly or annually.
The net income is total revenue minus total expenses. It’s this net number that is most often used before being combined with the multiplier to come up with a valuation.
The exact multiple is going to depend on a variety of factors that includes the industry, standards within the business type, the style of online business, and extraordinary considerations (incredible backlinks, an actual product, email list, social media channel, etc).
Asset Valuation Method
The asset valuation method is determining the fair market value of a business based on both actual book value assets in addition to valuation methods that are commonly used in the industry.
This is a more in-depth valuation method since it not only takes into account the pure profit numbers but also looks at things like stocks, bonds, investments, buildings, and both tangible & intangible assets during the valuation process.
Capitalized Future Earnings Method
The capitalized future earnings method gets a bit more complicated. Capitalized earnings are when a company takes future earnings and divides them by an expected capitalization rate.
This method makes a lot of assumptions when coming up with a valuation and expected rates of return on investment, however these assumptions are based on real life data. Based on (normally) years of earnings & market reports projections are made for what expected earnings are in the upcoming years.
This data is then used in negotiating a valuation of a business.
Comparable Sales Method
The comparable sales method is most often used in real estate versus online business. Comparable sales is just like it sounds like: a market approach that determines the value of an asset by looking at similar assets that have recently sold and pegging that as the current valuation range.
Variables That Enhance Value
While the profit numbers are always going to be the main basis for valuation, there are variables that can further enhance the value of a business.
For an online business the most common variables that enhance value above and beyond the profit numbers include:
- Extremely strong and hard to get quality backlinks
- Real or informational products
- Active and large social media followings
- Active email list
- Patents, copyrights, trademarks, or other brand-based assets
A well-prepared business report for investors that includes information on these can often help to increase the price an investor is willing to pay for a business.
Variables That Detract From Value
Just as there are certain variables that enhance the value of a business, there are variables that can also detract from the overall value, too.
The most common variables that detract from value include:
- PBN or spammy backlinks in profile
- High cost to profit ratio
- Any debt on the books
- Recurring expenses like advertisements
- Falling market trends
Having one or more of these potential red flags can drop the value of the business.
The Difference Between Appraised Value & Fair Market Value
Appraised value and fair market value can sometimes be the same thing or in the same range, but this won’t always be the case.
An appraised value is the value given to a business or asset based on an assessment from an investor or appraiser. This is the value that the asset is believed to have.
On the other hand a fair market value is the value or price that the asset can get on the current market based on what actual investors are willing to pay for it.
These values will normally be in the same general range, but at the end of the day the fair market value is going to be the one that represents what an investor is willing to pay for the business right now.
Business Valuation Examples
The business valuation process is often included in case studies of business purchases, so that’s always a great source of learning more.
Here are two hypothetical examples of how a business valuation might work.
Example 1: Content-Based Website (Earnings Multiple Method)
Valuation of a content-based website tends to be fairly simple and straightforward in most cases. In this example the website makes $4,200 a month on average based on the L12M earnings.
However, the site also has expenses of $200 a month, meaning the net profits are $4,000 a month.
After looking at backlink profiles, social media profiles, and other factors, the buyer and seller agree on a 40x multiple.
$4,000 x 40 = $160,000
This leads to a $160,000 sale price delivered via escrow as the earnings multiple method is a common sense, and standard method, for valuing content website businesses.
Example 2: Online Subscription Business (Capitalized Future Earnings Method)
A business based around recurring online subscriptions may have multiple ways to evaluate it, and the buyer and seller look at the capitalized future earnings method as a reasonable framework to agreeing on a valuation.
The last five years of the business show a 10% growth in subscriptions and profits every single year and a steady growth that matches the growth of the industry in general.
Based on the forecasts in the industry of the same growth over the next few years, the seller argues that the valuation shouldn’t be based on average yearly profits of the past year but needs to include the average expected raise in profits projected over the next three years.
Negotiations ensue, and the business doing $1 million a year is instead valued at $1.3 million a year based on rough projects for growth the next few years.
Take that time a 3.5x multiple for a SaaS business and instead of a $3.5 million valuation, it’s a $4.55 million valuation thanks to positive projections.
FAQ – Frequently Asked Questions
Here are answers to some of the most common questions about business valuation.
How to determine the value of a business when one partner wants to leave
Determining the valuation starts with the standard process, however when considering a valuation when a partner is going to leave can also involve other factors such as what assets the partner takes with them, the cost of replacing what they leave with, and projected lost projects or revenue. These numbers are negotiated to take them off the value of any payout.
What is an adjusted net profit margin?
These are adjustments that are made after the initial net profit numbers (gross revenue minus gross expenses) to reflect a more accurate average margin. This might take place if a major one-time sale happened during the last business quarter that was out of the ordinary and therefore throws off the average numbers.
How many times profit is a business worth?
How many times profit a business works depends on the industry and business style. A content website might be worth 40x monthly earnings while a SaaS business might sell for 3x to 5x its annual profit. The answer depends almost wholly on the type of business and the industry it’s in.