Andrew Markou is the CEO and Co-Founder of BusinessesForSale.com and has extensive experience in the business-for-sale market and the factors that influence valuation. He is also the author of A Pocket Guide to Buying a Business, which explains the acquisition process and explores how buyers can assess what a business is worth.
What is a business worth?
There is rarely one simple answer. A seller may have a figure in mind based on the years they have invested in the company. A buyer will usually take a more detached view, looking at earnings, assets, risk and the likelihood that the business will continue performing after the sale.
That difference is why valuation matters. The numbers provide evidence, but they still need to be interpreted.
After more than 30 years of helping owners bring businesses to market in the US and worldwide, we know that valuation is both financial and commercial. A credible figure needs to reflect not only what a business has earned, but how sustainable those earnings are and how attractive the opportunity looks to potential buyers.
In this guide, we explain how to value a business using the methods most commonly encountered in the US, including Seller’s Discretionary Earnings, EBITDA, asset-based valuation and discounted cash flow. We also look at valuation multiples, common mistakes and when it may be worth seeking professional help.
Tip: If you want an initial indication of what your business could be worth, our free ValueRight business valuation calculator can provide a useful starting point.
How Do You Value a Business?
A business can be valued by looking at its earnings, assets, revenue, future cash flow or the prices paid for comparable companies. For many profitable privately owned businesses, a useful starting point is:
Indicative business value = Maintainable earnings × Appropriate valuation multiple
Maintainable earnings are the profits a buyer could reasonably expect the business to continue producing. The multiple reflects market evidence and the specific strengths and risks of the company. We’ll break multiples down in greater detail later in this guide.
Neither figure should be chosen casually. A business with recurring revenue, steady growth and low owner dependence may justify a stronger multiple than another business in the same industry with volatile profits or high customer concentration.
The most appropriate earnings measure also depends on the type of company. In the US small business market, Seller’s Discretionary Earnings, or SDE, is commonly used for owner-operated businesses. EBITDA is more often applied to larger companies with independent management. Asset-heavy and investment-led businesses may require a different approach again.
Why is Business Valuation Important?
For sellers, valuation helps establish an asking price that can be defended with evidence. For buyers, it helps determine whether the price reflects the company’s earnings, assets and risks. Valuation can also be relevant when:
- Applying for acquisition financing
- Bringing a new investor or shareholder into the company
- Planning succession or transferring an ownership interest
- Certain SBA-backed acquisition loans may also encounter formal valuation requirements
Formal valuations may also be needed for tax, estate, gift, shareholder or legal matters. These assignments can require more rigorous analysis than an indicative valuation prepared simply to estimate a likely sale price.
Even if you are not planning to sell immediately, understanding how a buyer might value your company can help identify issues that could reduce its future worth, and increase its resilience.
What Information Do You Need to Value a Business?
A valuation is only as reliable as the information behind it. Ideally, buyers and sellers should review several years of performance rather than relying on a single recent result.
|
Information |
Why it matters |
|
Profit and loss statements for at least three years |
Show revenue, costs, profitability and performance trends |
|
Recent interim financial statements |
Provide a more current view than the latest year-end figures |
|
Business tax returns |
Help verify reported income against the financial information supplied |
|
Balance sheets |
Show assets, liabilities, cash and debt |
|
Cash-flow statements |
Reveal how reported profits translate into cash |
|
Owner compensation and benefits |
Help calculate the total financial benefit received by a working owner |
|
Discretionary and non-recurring expenses |
Identify legitimate adjustments to reported profit |
|
Asset records |
List equipment, property, vehicles and other business assets |
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Outstanding debts and liabilities |
Show financial obligations that may affect value |
|
Revenue by customer |
Reveal whether the company depends heavily on a small number of customers |
|
Contracts and recurring revenue |
Help assess the predictability and transferability of future income |
|
Forecasts and sales pipeline |
Provide evidence of future opportunities |
|
Leases, licenses and intellectual property |
Identify important rights, commitments and intangible assets |
Because privately held US companies are not generally required to publish detailed financial information in a centralized public register, buyers rely heavily on financial records supplied during the sale process and test them through due diligence.
Unexplained figures, unsupported add-backs or optimistic forecasts can weaken buyer confidence and reduce the amount they are prepared to pay.
What Are the Different Methods for Valuing a Business?
US valuation professionals often group valuation methods under three broad approaches:
- Earnings-based methods , including SDE and EBITDA multiples
- Asset-based methods , which look at what the company owns and owes
- Market and future-income methods , which use comparable transactions or expected future cash flow
The right approach depends on the company and the purpose of the valuation. In many cases, comparing the result of more than one method can produce a more credible range.
Seller’s Discretionary Earnings
Seller’s Discretionary Earnings, or SDE, is widely used to value smaller owner-operated businesses in the US.
It aims to estimate the total annual financial benefit available to one full-time owner-operator. To do that, it starts with reported earnings and adds back qualifying costs associated with the current owner.
These can include owner compensation and benefits, interest, depreciation, amortization and genuine non-recurring or discretionary expenses.
What Businesses are Best Suited to SDE Valuation?
SDE is particularly useful for smaller businesses where the owner plays an active day-to-day role. Examples include independent retail businesses, restaurants, trades, agencies and local service companies. These are sometimes described as Main Street businesses in the US market.
SDE is most relevant where the buyer expects to replace the seller as the working owner. Once a business has independent management and is less dependent on one individual, EBITDA may become the more useful measure.
What is the Formula for SDE?
A simplified calculation is:
SDE = Pre-tax income + owner compensation and benefits + interest + depreciation and amortization + eligible discretionary expenses + non-recurring expenses
Once SDE has been calculated, a suitable multiple can be applied:
Indicative business value = Maintainable SDE × SDE multiple
A Simple SDE Valuation Example
Imagine an owner-operated marketing agency reports annual pre-tax income of $120,000. The owner receives $80,000 in compensation, while another $20,000 consists of legitimate one-time or discretionary costs that a new owner would not inherit. The SDE would be:
$120,000 + $80,000 + $20,000 = $220,000
If market evidence supports a multiple of three, the indicative value would be:
$220,000 × 3 = $660,000
That does not mean the company will necessarily sell for $660,000. The multiple still needs to reflect growth, margins, customer concentration, owner dependence and other risks.
EBITDA Multiple
EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is commonly used to assess the underlying operating profitability of established businesses where earnings are less dependent on one working owner.
What Businesses are Best Suited to EBITDA Valuation?
EBITDA is generally more relevant to businesses with a management structure capable of running the company independently of its owner. It is therefore commonly encountered as companies move beyond the Main Street market and into larger or lower-middle-market transactions.
There is no universal size threshold at which SDE stops and EBITDA begins. The important distinction is whether the buyer is acquiring an owner-operated business or an organization whose earnings can continue without the current owner performing a central operational role.
What is the Formula for EBITDA?
A simplified formula is:
EBITDA = Net income + interest + taxes + depreciation + amortization
The valuation formula is:
Enterprise value = Maintainable EBITDA × Appropriate EBITDA multiple
EBITDA can make it easier to compare companies with different financing structures. However, it is not the same as cash flow. It excludes capital expenditures and changes in working capital, both of which can affect the amount of cash the company actually generates.
Asset-Based Valuation
An asset-based valuation considers the value of what a company owns and subtracts what it owes. The basic formula is:
Net asset value = Total assets − total liabilities
Assets may include real estate, equipment, vehicles, inventory, cash and accounts receivable. Liabilities can include loans, unpaid suppliers, tax obligations and other debts.
What Businesses Are Best Suited to Asset-Based Valuation?
Asset-based approaches are most useful where tangible assets account for a substantial proportion of the company’s value. Examples include manufacturers, agricultural businesses, real estate companies and businesses with valuable equipment or inventory.
They tend to be less useful where the company’s main value lies in its brand, employees, customer relationships or ability to generate future profits.
Book Value vs Fair Market Value
The figure shown on a balance sheet may not reflect what an asset is worth today. Equipment may have depreciated substantially since it was purchased. Real estate may have increased in value. Inventory can become obsolete, and some accounts receivable may not be collected in full. For that reason, an asset-based valuation may need to adjust book values to reflect fair market value.
Liquidation Value
Liquidation value estimates what the company’s assets might realize if they had to be sold and its liabilities settled.
A forced or time-limited sale will often produce less than an orderly sale. Liquidation value is therefore more relevant to distressed or underperforming companies than to healthy businesses being sold as going concerns.
Discounted Cash Flow Valuation
Discounted cash flow, or DCF, values a company according to the cash it is expected to generate in the future. It reflects the principle that a dollar received today is worth more than a dollar received several years from now. Forecast cash flows are therefore reduced using a discount rate that reflects time and risk.
DCF value = [CF₁ ÷ (1 + r)¹] + [CF₂ ÷ (1 + r)²] + … + [CFₙ ÷ (1 + r)ⁿ] + discounted terminal value
CF is the forecast cash flow for each period, r is the discount rate and n is the period number. Terminal value represents the estimated value of cash flows beyond the explicit forecast period.
What Businesses are Best Suited to DCF Valuation?
DCF is most useful where future cash flows can be forecast with reasonable confidence. It is often better suited to larger or more established companies than small owner-operated businesses with volatile earnings.
Its main weakness is its sensitivity to assumptions. Small changes to expected growth, margins or the discount rate can have a substantial effect on the result. If the forecasts themselves are unreliable, the valuation will be too.
Which Business Valuation Method Should You Use?
No single valuation method is best in every situation.
|
Type of business |
Potential starting method |
|
Small owner-operated business |
SDE multiple |
|
Established business with independent management |
EBITDA multiple |
|
Asset-heavy company |
Adjusted net asset valuation |
|
Distressed or loss-making business |
Asset-based or liquidation valuation |
|
Stable company with predictable cash flows |
Discounted cash-flow valuation |
In practice, buyers, brokers and valuation professionals often compare several approaches before settling on a range. Comparable transactions can then be used to test whether the result makes sense in the current market.
What is a Valuation Multiple – and How is it Chosen?
A valuation multiple reflects how the market assesses the earnings and risk of a business.
If comparable companies have recently sold for between 2.5 and 3.5 times SDE, that may provide a useful range. But businesses in the same sector can still differ significantly in growth, margins, customer concentration, owner dependence and other factors.
A company with long-term contracts, recurring revenue and a strong management team might justify a higher multiple than another business with similar earnings but much greater risk.
US business brokers and valuation professionals may draw on transaction databases, industry information and experience from completed deals when assessing multiples.
Some sectors also have commonly quoted rules of thumb, such as a percentage of revenue or a typical SDE multiple. These can provide a useful sense-check, but they should not replace analysis of the individual company.
Location can also influence value. Labor costs, rents, local taxes, population trends and the size of the potential buyer pool can all affect what buyers are willing to pay.
The key question is not simply what multiple is common in an industry, but whether that multiple can be justified for the business being valued.
Five Common Business Valuation Mistakes
Valuation involves judgment, which means there are several places buyers and sellers can go wrong.
Applying a Multiple to the Wrong Figure
SDE, EBITDA, net income, revenue and cash flow are not interchangeable. If comparable sales use an SDE multiple, that multiple should be applied to SDE. Applying it to EBITDA or another financial measure can significantly distort the result.
Making Unrealistic Adjustments to Profit
Sellers may be tempted to add back every expense that makes earnings look stronger. Owner compensation, genuine personal expenses and one-off costs can sometimes be legitimate adjustments. Normal operating costs are not.
Relying Too Heavily on One Year
An unusually strong year does not necessarily show what a business can continue earning. Valuation should consider several years of performance, recent financial statements and the reasons behind any major increase or decline in earnings.
Double-Counting Assets
Where a business is valued using earnings, the assets required to produce those earnings may already be reflected in the result. Adding the full value of ordinary operating assets afterwards can count the same economic value twice. Buyers and sellers should therefore be clear about what is included in the transaction and whether any surplus assets are being valued separately.
Treating the Valuation as a Guaranteed Sale Price
A valuation is an informed estimate rather than a guaranteed outcome. The eventual price can be influenced by buyer demand, due diligence, financing, negotiation and deal structure. New information may reduce what a buyer is prepared to pay, while competition between several serious buyers can push the final price higher.
Can You Value a Business Yourself?
The formulas in this guide can help you produce an indicative valuation range if you have reliable financial information and understand which earnings measure to use. For a more detailed starting point, BusinessesForSale.com’s ValueRight business valuation tool can examine the company’s financial information in greater depth.
If the valuation is required for financing, tax, estate, gift, litigation or shareholder purposes, you may need a professional with appropriate business valuation experience.
In the US, this could include a CPA with specialist valuation expertise or a credentialed business appraiser. Professional credentials include the AICPA’s Accredited in Business Valuation (ABV) designation and business valuation credentials offered by the American Society of Appraisers (ASA). Business brokers may also provide valuable market insight, particularly when they have experience selling similar companies in the same sector or region.
Finding the Right Value
No single formula can capture everything that makes a business valuable. Its financial statements matter, but so do the quality of its earnings, the strength of its customer relationships, its dependence on the owner and the risks a buyer will inherit.
For smaller US businesses, valuation may begin with SDE and comparable sales. Larger companies may be better suited to EBITDA or income-based methods, while asset-intensive businesses may require greater focus on the balance sheet.
The strongest valuations combine sound financial analysis with a realistic understanding of the company, its market and what a buyer is actually acquiring.