The problem with business valuation calculators

There are many business valuation calculators and tools out there that claim to be the best and most accurate way to determine the value of your business. However, these calculators are not the solution for business owners looking to sell and can be dangerous if used without careful consideration.

In this article, we’ll discuss the pitfalls of business valuation calculators and why owners should explore other methods to determine 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 websites online that promise to give them a review for their business. They enter basic financial information (never a good thing) and their industry classification, and the website returns a valuation range for their business.

Online business valuation calculators work by taking basic financial metrics like income or EBITDA (earnings before interest, taxes, depreciation, and amortization) and then multiplying those numbers by standard multiples of the industry based on public companies or comparable private sales transactions. They can take only the previous year’s income and EBITDA, or they can take the average of the number of years passed.

Why Are Online Business Valuation Calculators Usually Wrong?

Not all cash flow is created equal. In other words, two companies in the same industry with the same income and the same EBITDA can have very different valuations.

For example, let’s say we have two companies with identical financial data, but one company (Company A) has 50% of its business linked to a large customer, does not have a deep management team, has pending litigation and does not own the right brands to operate his business. The second company (Company B) has broad customer base, a deep management team, no litigation, and really clean books and records, including proper ownership of all of its intellectual property.

Most online business valuation calculators will give Business A and Business B the same valuations or valuation ranges because their valuations are based entirely on companies’ financial results and industry classifications. This is obviously wrong.

In our case, Company A would be significantly overvalued and Company B could be significantly undervalued. There is a significant difference between a business that buyers would value three times EBITDA and a business that buyers would value seven times EBITDA.

But what is this difference?

The difference between a company that would trade for three times EBITDA and a company that would trade for seven times EBITDA (both in the same industry) is due to the different levels of risk in these two companies.

In our case, company A has a lot more risk than company B. Company A has a thin management team, which makes the company too dependent on the owner; its income is too concentrated on a single client; he has disputes that expose him to non-quantifiable risks; and it does not own its trademarks. Any of these risks could expose it to business problems that could reduce its future EBITDA, which will reduce a buyer’s return on investments. In short, a business that is more risky means it is less valuable, and online business calculators typically ignore the dozens of risks that a business might have.

Why are online business valuation tools dangerous?

For a business owner who wants to know the value of their business, either to start financial planning for their family or to start discussions with a potential investor or buyer, these online business valuation tools can be used. very dangerous.

Take business A. The typical online business valuation calculator will provide a much higher valuation than it would get in the market. If the owner of Company A is doing financial planning and intends to use the proceeds from the sale of Company A to fund his retirement, he will have overly optimistic assumptions about what the sale of his business will be. will generate. This can cause them to waste time and money trying to sell their business, only to find out later that the business is not worth what they thought it was.

Take business B. The typical online business valuation calculator will provide a much lower valuation than it would get in the market. If the owner of firm B started negotiating with a potential buyer of his business, he could leave money on the table either (a) by offering to sell his business at a below-market valuation, or ( b) taking an offer from a buyer that is lower than what they would have obtained under a larger auction process in the market.

Either way, relying on an unsophisticated and incomplete valuation from an online business valuation calculator costs owners valuable time and money. And in the case of business owner A, the owner missed a valuable opportunity to work on the risks that were reducing the value of his business. had they been aware of these risks and their impact on value a few years earlier, they could have taken steps to correct them and increase the value of their business.

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