Determining your company’s value: The problem with business valuation calculators
Wednesday, February 24, 2021
There are numerous business valuation tools and calculators out there that claim to be the best and most accurate way to determine your company’s worth. However, these calculators are not the answer for business owners looking to sell and can be dangerous if used without careful consideration.
In this article, we will discuss the pitfalls of business valuation calculators and why owners should explore other methods for determining the value of their business.
What is an online business valuation calculator?
Business owners often surf the internet to find out how to value their business. They will come across hundreds of online websites that promise to give them a valuation for their business. They enter some basic financial information (never a good thing) and their industry classification, and the website will spit back a valuation range for their business.
Online business valuation calculators work by taking basic financial metrics like revenues or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and then multiplying those numbers by standard industry multiples based on either public companies or comparable private sale transactions. They might take just the prior year’s revenues and EBITDA, or they might take an average of the past number of years.
Why are online business valuation calculators usually wrong?
All cash flows are not created equal. In other words, two businesses in the same industry with the same revenues and same EBITDA can have wildly different valuations.
For example, let’s say we have two businesses with identical financials, but one business (Business A) has 50% of their business tied up with one large customer, does not have a deep management team, has some pending litigation, and does not own the right trademarks to operate its business. The second business (Business B) has wide customer diversification, a deep management team, no litigation, and really clean books and records, including proper ownership of all its intellectual property.
Most online business valuation calculators are going to give Business A and Business B the same valuations or valuation ranges because their valuations are based entirely on the financial results and industry classifications of the businesses. This is obviously wrong.
In our case, Business A would be significantly overvalued, and Business B might be significantly undervalued. There is a significant difference between a business that buyers would value at three times EBITDA and a business that buyers would value at seven times EBITDA.
But what is this difference?
The difference between a business that will trade for three times EBITDA and a business that would trade for seven times EBITDA (both being in the same industry) is due to the different levels of risk in these two businesses.
In our case, Business A has much more risk than Business B. Business A has a thin management team, making the business too dependent on the owner; its revenues are too concentrated with one customer; it has litigation that exposes it to unquantifiable risk; and it doesn’t own its trademarks. Any one of these risks could expose it to business problems that could reduce its future EBITDA — which will decrease the investment returns of a buyer. In short, a business that has more risk means it is less valuable, and online business calculators don’t typically account for the dozens of risks a business might have.
Why are online business valuation tools dangerous?
For a business owner who wants to know what their business is worth to either start financial planning for their family or start discussions with a potential investor or buyer, these online business valuation tools can be very dangerous.
Take Business A. The typical online business valuation calculator is going to deliver a valuation that is much higher than they would get in the market. If the owner of Business A is doing financial planning and intends to use the proceeds of a sale of Business A to finance their retirement, they will have overly optimistic assumptions about what the sale of their business will generate. This can cause them to waste valuable time and money trying to sell their business, only to discover later that the business isn’t worth what they thought it was.
Take Business B. The typical online business valuation calculator is going to deliver a valuation that is much lower than they would get in the market. If the owner of Business B were beginning to negotiate with a potential buyer of their business, they might leave money on the table by either (a) offering to sell their company at a lower-than-market valuation, or (b) taking an offer from a buyer that is lower than they would have gotten in a broader market soft auction process.
In both cases, relying on an unsophisticated, incomplete valuation from an online business valuation calculator cost the owners valuable time and money. And in the case of the owner of Business A, the owner missed a valuable opportunity to work on those risks that were reducing the value of their business — if they had known about these risks and their impact on value a couple years earlier, they could have taken steps to fix them and increase the value of their company.
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