How Is a Company Valued?

We are frequently asked questions that center around the concept of business valuation—sometimes directly, and other times through related questions like, “Do I get to keep my receivables?” To help clarify, we’ve outlined the two primary approaches to valuing a business: a Balance Sheet-based valuation and a Cash Flow-based valuation.

This article serves as an introduction to these concepts. In future content, we will dive deeper into related topics referenced here.

1. Net Asset Value (Balance Sheet-Based)

This method values the company based on what it owns minus what it owes—assets like cash, equipment, inventory, receivables, and real estate, minus any liabilities. This approach is most common when:

• A business has significant tangible assets

• It’s not very profitable

• It’s being shut down or liquidated

Think of it like selling off the pieces of a business one by one.

 2. Cash Flow Valuation (More Common)

This is the go-to method for valuing healthy, profitable businesses. It focuses on how much cash flow the business generates and discounts it for risk. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is the starting point for many. However, when sellers say, “My business is worth 5x EBITDA,” they often don’t realize that Buyers are evaluating cash flow and simply presenting the valuation as an EBITDA multiple to make it easier for the seller to understand. Think of it as showing a home price as a price per square foot, so the Seller knows if they are getting a good fair or not. After EBITDA, Buyers will review capital expenditures and net working capital needs, as those are cash requirements to fund regular day-to-day operations and growth. A company’s ability to consistently convert revenue into cash is what drives the value of the Company.

Valuation in Practice: McSample Industrial Services

Below is an exhibit showing the financial statements for a fictitious Company, McSample Industrial Services. 

Exhibit I - McSample Industrial Services

Income Statement, Balance Sheet, and Cash Flow Statement

Note: See Appendix for a glossary of terms

Net Asset Value (Balance Sheet-Based). Reviewing the Balance Sheet, we can see the Company has $9.040 million in Total Assets and $4.936 million in Total Liabilities. The value is then determined by taking Assets less Liabilities to get to a value of $4.104 million.

Cash Flow Valuation (More Common). Reviewing the financial statements, the Company generates $2.645 million of EBITDA on $13.196 million of Revenue. Reviewing the last two years, the company grew Revenue by 6.0% and EBITDA by 6.3%, supported by Gross Margins, which increased 7.2%. This all seems reasonable and sustainable at first pass (Note, this will be subject to considerable due diligence after a LOI is signed). McSample is generating Free Cash Flow, measured by (EBITDA – Capex) / EBITDA, of approximately 85%, which is good (greater than 80% is desired, and over 90% is preferred). Below 80% and we would expect better than industry growth rates for significant capital being invested, or we would expect to discount the valuation deduction (read: reduced EBITDA multiple vs comparable EBITDA multiples). Finally, Net Working Capital is approximately 23% of revenue. Most industrial service businesses are going to be in the 20%-30% range, so this is in line with expectations. We will cover Net Working Capital in future articles. So, we consider Revenue, growth rate, EBITDA, EBITDA margin, Capital Expenditures, and Net Working Capital as a percent (%) of sales and we feel comfortable that a value of $14.0 million is the right price to propose in an initial indication of value to the Seller. The price translates to a 5.29x 2024 EBITDA. The Buyer uses the implied EBITDA multiple to provide confirmation that the $14.0 million price determined by reviewing cash flow is appropriate.

Takeaway. When comparing the two valuation methods, the cash flow valuation comes to a more attractive price for McSample Industrial Services.

Note, all professional investors and buyers would review at least the last three years of financial information (EBITDA, Capital Expenditures, Net Working Capital), sales and margin by service, project, and customer, as well as review things like the leadership team depth, tenure of employees, turnover data, and quality control processes around estimating, project set up, and execution as they evaluate risk, which is a meaningful influence on the EBITDA multiple. In addition, a note on high growth rates, investors/corporate buyers do not know your business as well as you do. As such, they are likely to discount its sustainability if they see Revenue and EBITDA margins that jumped more than 10% in a year immediately before a sale/investment.

In general, most buyers/investors sanity check their valuation by looking at two and three year averages for their EBITDA multiple, as well as what is the multiple paid for Free Cash Flow (FCF) as defined as EBITDA minus Capex. They compare the implied multiple against the comparable set, as well as a larger macro set of EBITDA multiples to provide guidance on the figures derived from their analysis. In summary, it would be incorrect to simply apply an EBITDA multiple to a business without taking into account the underlying cash flow and risk (i.e., EBITDA size, EBITDA Margin, customer concentration, management depth, capital expenditure requirements, net working capital requirements, competition, and other similar factors).

What About My Receivables and the Trucks I Bought Last Year?

Summary

A lot of business owners hear “5.0x EBITDA” and assume that means they get “the multiple” and walk away with all their receivables, trucks, and other assets in addition to the 5.0x price. Unfortunately, that is not how it works.

Investors/corporate buyers expect to receive what they need to keep the business running—including:

• Accounts receivable

• Inventory

• Accounts payable

• Equipment

Here’s the key point:

If the investor or corporate buyer is paying based on your cash flow (e.g., a 5.0x EBITDA multiple), then the assets that generate that cash flow—such as receivables and trucks—are included in the price. You don’t get to keep those and sell the earnings they create.

Imagine selling a rental property. If the price is based on the income it generates, the buyer expects it to come with plumbing, a roof, and maybe even tenants. They’re not going to pay for the income the rental property (which includes a functioning roof) produces and then pay again for a roof.

Understanding Net Working Capital (NWC)

Net Working Capital is the difference between a company’s current assets (excluding cash) and its current liabilities (excluding debt, such as its revolving line of credit, capital lease obligations, and the current portion of long-term debt). Net Working Capital is the ins and outs of cash that keep the business going day-to-day. This includes receivables, inventory, payables, and accrued expenses. Every business needs a certain amount of working capital just to keep the wheels turning—billing customers, paying vendors, and keeping products in stock.

Investors and corporate buyers expect to receive a “normal” amount of working capital at closing. If they did not, they would have to inject extra cash just to get the business to function on Day 1. To that point, most deals in the lower middle market are structured as cash-free, debt-free, with a Net Working Capital Adjustment to ensure a normalized level of working capital. The Seller keeps the cash, pays off the debt (such as the revolving line of credit, capital lease obligations, and term loans), and delivers a mix of current assets and liabilities needed to operate the business from Day 1 without an additional capital investment post close to keep the lights on, make payroll, and/or meet other normal course business obligations.

Note, Working Capital must be at a “normal” level at closing. Normal typically means the 12-month average Net Working Capital balance. The standard adjustment is a two-way adjustment. That means if you deliver more than needed, the Buyer gives you cash for the additional Net Working Capital that was delivered. Conversely, if you deliver less than needed, you need to leave some cash behind to fund that difference. We will cover more on Net Working Capital in future articles.

Understanding Capital Expenditures (Capex)

These are the ongoing investments needed to keep the business running: equipment, trucks, systems, facilities, etc. Even if a Seller skipped spending this year, buyers will factor in what’s needed to sustain operations over time. Capital expenditures is factored into the multiple (lower cash flow = lower multiple).

Is the Business Worth the Same as My Proceeds?

In short, no. Much like selling a house, what you keep depends on a lot of factors, such as the mortgage balance. Unlike a home, companies can have cash and also have Net Working Capital to be factored in. Below are two simple formulas to help you understand the difference

• Enterprise Value = The Price the Company is Worth. This is what someone says when they tell you, “I sold my business for 6.0x EBITDA,” as an example

  
  

• Net Proceeds = Enterprise Value – Debt + Cash +/– NWC Adjustment. This is the money you keep.

Note, we will not discuss net proceeds factoring in tax, as tax is too complicated to cover in this introductory article. Please consult your CPA to better understand your net tax proceeds. 

Takeaways for Sellers

If you’re expecting a price based on an EBITDA multiple—you need to know what’s included in that price:

• You don’t get to keep the receivables, the trucks, or inventory.

• You do keep your cash and pay off your debts.

• Buyers will have adjust the overall valuation for capital expenditures and working capital needs.

• The multiple is a sanity check to the value of the cash flows the company generates.

Understanding this ahead of time will help you avoid frustration, negotiate better, and walk into the sale process with clear expectations.

Glossary

Plant Property & Equipment (PP&E). PP&E refers to the sum of a company's long-term tangible assets in the categories of plant, property, and equipment. These are often reported as either Gross or Net values:

• Gross PP&E reflects the original purchase price of the assets.

• Net PP&E subtracts accumulated depreciation from the Gross amount.

• Example:

If a truck is purchased in Year 1 for $100,000 with a 5-year useful life, it would be reported as:

• Gross: $100,000 (unchanging over time)

• Net: $80,000 after Year 1 (i.e., $100,000 – $20,000 in depreciation)

By the end of Year 2, the Net value would be $60,000, accounting for two years of depreciation.

Capital Expenditures (Capex). CapEx refers to funds a business uses to acquire, upgrade, or maintain long-term assets such as buildings, vehicles, or machinery. These expenditures are capitalized and depreciated over time rather than expensed immediately.

Net Working Capital (NWC). NWC is typically defined as: Current Assets (excluding cash) – Current Liabilities (excluding debt-like items). This metric reflects a company’s liquidity and ability to meet short-term obligations.

Simplified Exhibit:

Note: "Debt-like items" may include short term portion of debt, revolving line of credit, accrued interest, capital leases, or short-term notes payable are not part of operating working capital.

Free Cash Flow (FCF). In this article, we define Free Cash Flow as: EBITDA – CapEx. While the true Free Cash Flow figure appears on a company’s Cash Flow Statement, this simplified version helps illustrate the cash generated before adjustments for changes in Net Working Capital (e.g., Accounts Receivable Days, Inventory Turns, and Accounts Payable Days).