Online calculators: How they can be dangerous when looking for a realistic business valuation

Do you have an accurate estimate of how much your business is worth?

Many owners believe they can arrive at a quick answer by doing a few “back-of-the-envelope” calculations or plugging numbers into an online calculator. But these procedures ignore important variables and can lead to inaccurate results. Relying on them can negatively affect your business decisions, give you a false sense of security and interfere with your retirement plans. 

If a business owner has an unrealistic idea of the value of their business, they may be surprised to find a “gap” between the current value of their company and where the company value needs to be to meet retirement goals — especially after factoring in taxes that may be owed on a business sale. Online business valuation calculators or “back-of-the-envelope” calculations can significantly undervalue as well as overvalue a business. 

Why a business valuation needs more than an online calculation

A business appraiser will consider many facets of a company, including excess working capital and other assets, realistic expectations of the future income, assets anticipated to be included in a sale, normalized income and expenses, industry and economic trends, and the impact financing will have on a buyer’s ability to pay a certain price.

An online business valuation calculator can’t take all the facets into consideration when calculating a value that would be considered in negotiations between buyers and sellers. An experienced business appraiser stays abreast of current market conditions and will factor in those considerations when preparing a business valuation. Understanding the buyer’s and seller’s viewpoints is what a business appraiser does and is important to assessing a reasonable value for a business.   

What buyers are looking for

While sellers are normally looking for the highest price, buyers want a return on their investment. They are much more interested in the future than in last year’s results. If changes in future earnings are anticipated, the buyer will factor that into a purchase price they offer.   

Your income might depend on loyal customers, some of whom will depart if you sell, particularly if you or your salespeople have personal relationships with them.

Perhaps the business relies on your management expertise or technical skill to generate income. Will the new owner have equivalent skills?

Questions like this don’t have easy answers, but they’re important to buyers. In valuing your business, you need to see them like a buyer does — as risks that need to be accounted for.

Using the right multiple

The market approach is a common approach to valuing a business. This approach looks at historical transactions involving comparable businesses and calculates multiples paid based on the purchase price and that company’s historical earnings. By looking at other business transactions, you can determine the average multiple for your industry. 

However, many transactions that are included in databases have special considerations factored into those multiples, such as synergies gained or future income that is expected to be greater than the historical. If multiples are not adjusted, they may skew the business value results.    

Just applying a multiple and not digging into why the multiple is higher or lower doesn’t go deep enough to provide an accurate valuation of your business. Sometimes there are different assets or liabilities factored into a price, sometimes there were nonrecurring expenses or income in the earnings number, and sometimes there are owner-related adjustments that should have been made. These are just a few things that online calculators can’t really identify, and a business owner may not understand what “normal” adjustments would be made when negotiating between a buyer and a seller.

During the COVID-19 crisis, many businesses are experiencing nonrecurring income losses, while others that sell products like antibacterial soap, toilet paper or face masks are experiencing windfall gains.  These are some items that may not show up on last year’s financials but could have an impact on the current value of a company.  

Growth prospects

Another critical factor in business value is growth. To buyers, that means future growth.

Everyone wants their business to grow, and sellers may tend to be overly optimistic. You might be hoping for 10% growth next year, even though your growth rate has averaged 3% in the past. Plugging your projections into an online calculator can make those numbers seem real and achievable but also arrive at an inflated business value that a buyer would not pay for the business. While you think you may be entering a reasonable growth assumption into the calculation, buyers are going to want a seller to justify their projections.

Have you invested in promising new technology? Acquired new customers? Are you producing new products or services that are generating additional revenue? The only growth prospects that matter in a sale are the ones you can quantify.

Supply and demand

Supply and demand affect the value not just of your goods, but also of your company as a whole. In good economic times, the supply of buyers exceeds that of sellers, and competing buyers drive prices up. In bad times, the reverse is true. The economic climate at the time of the sale has an enormous impact on the worth of your business, so multiples and value will change depending on the current environment.

Assets and liabilities

If anything is straightforward and easily quantifiable, it’s assets and liabilities — or so you’d think. But it’s easy to exclude important elements, especially if you’re using an online calculator.

Understanding the assets and liabilities in a transaction, even those not recorded on a company’s balance sheet, is important to consider. For example, maybe you work with a labor union whose pension obligations are tied to the company but not recorded on the balance sheet. This is a number that is overlooked by online calculators, but not accounting for it is asking for trouble.

The seller might assume that the buyer will take on the pension liability, while the buyer assumes that the seller is responsible. These misguided assumptions cover sums in the millions of dollars. Once negotiations are underway, the buyer might insist that the seller pay. The seller, realizing that payment would erase the cash he expected to walk away with and retire on, refuses to sell. After a lot of wasted time and money, the deal falls apart.

Assets, too, might be unaccounted for. In addition to buildings and equipment, your business might own a car, a plane or fine art. Insurance also carries a cash value. These “excess assets” may not be on the books or be hidden from the inexperienced, but they can have value that would increase the value of your business or the net cash you would generate on a sale.

Intangible assets are often not listed on a company’s balance sheet. Intangibles that are transferrable, like patents, can increase the sale value of your business. Intangibles that depend on personal skills or relationships can’t be transferred and therefore carry a risk for buyers that might lower the value of your business in their eyes.

Online calculators can’t individually identify these assets. But a business appraiser will consider intangible assets and the amount of intangible assets that may continue after the sale or stay with the seller.

You also need to account for excess inventory, which you might have taken on debt to acquire, but which hasn’t yet sold to produce income. And don’t forget about past or future capital expenditures that would increase the value of the business in the future that may not be factored into a simple calculation.  Online calculators don’t account for these factors, but such factors are an integral part of determining your company’s value.

Obtaining an accurate valuation

As you can see, obtaining a realistic valuation of your business — one that brings about a fair market value acceptable to both buyer and seller — is a complex endeavor that includes many factors you won’t find in online calculators.

Having an accurate valuation is not only essential to a sale, it’s also an important aspect of planning throughout the life of a business. Decisions about purchases, loans, spending and capital investment can only be made with confidence if you have a realistic and objective understanding of your company’s worth.

For many owners, the business is a nest egg they’re counting on to secure their future. To avoid the shock and heartache of a postponed retirement, you owe it to yourself to obtain a thorough and objective business valuation, even if you don’t plan on selling anytime soon.

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