Small business valuation calculator

The generally accepted method of calculating small business valuations is to use the discounted cash flow (DCF) technique which basically involves compiling a cash flow forecast for the small business and discounting these cash flows by the weighted average cost of capital (WACC).

What is important to note is that there is no definitive scientific approach which guarantees a certain level of accuracy. The nature of the small business valuation is inherently subjective within reason and dependent on the level of risk that the buyer would be willing to take on and cost of capital that the buyer intends to use.

Let me explain - if one buyer is able to finance a small business acquisition from borrowed capital entirely and another buyer intends to use his own capital, their cost of capital would not be the same. You see, when using the bank's capital, the subjectivity of the cost of capital is limited to a difference in the interest rates which can be negotiated on a bank loan. It is therefore not likely to differ materially.

But when it comes to one's own capital, there will in all likelihood be more subjectivity. One buyer may be satisfied with a 15% return on his investment but another may require 20% or 25%. This is largely dependent on the other investment opportunities that are available to the buyer and the likely investment return on these opportunities as well as the level of risk.

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For example, if a potential buyer of a small business can obtain an investment return of 15% on a passive share portfolio investment and the likely return on buying a small business is also 15%, why would the buyer take on significant additional risk to buy the business?

The cost of capital is also not the only subjective area of small business valuations when using discounted cash flow. The period over which the valuation is calculated is another subjective decision and even just deciding between a three or five year period can have a significant impact on deciding to purchase a business or not.

The basic principle is that the higher the risk associated with purchasing the business, the shorter the period to include in the valuation calculation. This basically means that with a high risk purchase, you would want to make back the funds invested quicker. If there is a relatively lower risk associated with the business, you would be more comfortable calculating returns and therefore valuations over longer periods.

The there is also the issue with regards to the terminal value approach which is commonly used in corporate business valuations. This basically involves including an additional value in the estimated business valuation to provide for cash flows which are received after the end of the business valuation period and into perpetuity.

With corporate acquisitions which are generally lower in risk than small business valuations, it makes sense to include a terminal value but small business valuations are generally higher risk investments and investment payback is therefore required over shorter periods during which less can go wrong! Including a terminal value in such investments is not usually appropriate but as we are highlighting here, there is an inherent level of subjectivity to these small business valuations!

Finally, we recommend using a small business valuation calculator which contains sufficient flexibility that you can run various scenarios to test the sensitivity of the estimated business valuation to fluctuations in all of the main calculation variables. By following this approach, you should arrive at a valuation that you are comfortable with whether you are the buyer or the seller of the business!