How to Value a Small Business: Three Methods

It will not. A serious valuation uses two or three different methods and looks at where they agree. The methods rarely produce identical answers, and that is the point. The gap between them tells you something useful about your business. When the methods converge, you have a defensible asking price. When they diverge by 40 percent or more, you have a story to figure out before you go to market.

Professional appraisers organize valuation methods into three categories, sometimes called the three approaches to value. Every method that exists falls into one of these buckets. Understanding what each bucket measures, and when each one matters, is how you stop being talked into a number by someone with a commission attached to the outcome.

The market approach

This approach values your business by comparing it to similar businesses that have actually sold. It uses transaction data from real deals, applies an industry-derived multiple to your earnings, and produces a price that reflects what the market is currently paying. The market approach is grounded in evidence rather than projection, which is its main strength.

The income approach

This approach values your business based on the cash flows it is expected to produce in the future, discounted back to today using a rate that reflects risk. The income approach answers the question: if I were the buyer, how much should I pay today for the right to receive this business's cash flows over the next five to ten years? It is theoretically the most rigorous method, and the most sensitive to assumptions.

The asset approach

This approach values your business based on the value of its underlying assets, both tangible and intangible. It is most appropriate when the business has significant physical assets like real estate, specialized equipment, or inventory. The IRS Excess Earnings Method is a hybrid that combines the asset approach with elements of the income approach.

For an owner-operated small business, all three approaches are useful, but they are not equally weighted. The market approach (using SDE multiples) does most of the work. The income approach (DCF) serves as a sanity check. The asset approach (Excess Earnings) shows up in specific situations, mostly tax and legal. The rest of this article walks through each method in detail and then shows how to combine them.

Which method applies to your business

The three methods overlap, but each one is built for a particular kind of business and a particular purpose. The table below shows when each method should be the primary approach.

If you are a typical BizTender seller, your business is in the first row of that table: owner-operated, under about $3 million in revenue, with reasonably stable earnings. The SDE multiple method is your primary tool. DCF is a useful cross-check. The Excess Earnings Method probably will not feature in your sale, but you should understand it because your CPA may mention it during planning conversations and because an SBA appraiser may use it as part of a third-party valuation.

Method 1: The SDE multiple (market approach)

The SDE multiple method is the workhorse of small business valuation. The vast majority of businesses that change hands in the United States each year are priced using some version of this approach. It is widely used because it works: the math is simple, the inputs are verifiable, and the results reflect what buyers and lenders actually pay.

The two inputs each carry weight. SDE is covered in detail in our complete guide to Seller's Discretionary Earnings. The short version: SDE is the cash flow available to one full-time owner-operator after add-backs for owner compensation, interest, depreciation, amortization, one-time expenses, and documented discretionary expenses.

The multiple comes from transaction data. Three databases collectively cover most small business transactions in the United States.

Where multiples come from

DealStats (formerly Pratt's Stats) is the most comprehensive paid subscription database. It tracks several thousand small business transactions per year, indexed by industry NAICS code, with the actual closing multiples reported by the brokers and intermediaries involved. Professional appraisers rely on DealStats more than any other source.

BizBuySell Insights publishes free quarterly reports summarizing transactions that closed through the BizBuySell marketplace. The data is less granular than DealStats but freely accessible, and the trends are reliable indicators of where the market is moving.

PeerComps focuses specifically on transactions financed through SBA 7(a) loans. Because SBA lenders order independent appraisals for most acquisition loans, PeerComps captures the prices at which deals actually financed, not the asking prices. This makes it especially useful for sellers who anticipate an SBA-financed buyer, which is most sellers under $3 million.

Selecting your multiple

Once you have access to transaction data for your industry, you do not just take the median multiple and call it done. The median tells you the middle of the range. Your business sits somewhere in that range based on specific factors, and the factors that move you up or down are well-documented.

Factors that push the multiple toward the high end of the range:

• Recurring revenue from contracts, subscriptions, or maintenance agreements
• Customer base with no concentration risk (no single customer over 10 to 15 percent of revenue)
• Owner working fewer than 40 hours per week or replaceable management in place
• Three years of growing SDE and revenue
• Clean books that reconcile to tax returns without significant adjustments
• Documented operating procedures and trained employees
• Industry tailwinds or consolidation activity
• Lease with five or more years of secured tenure

Factors that push the multiple toward the low end of the range:

• Owner working over 50 hours per week with no replaceable management
• Customer concentration with one customer over 25 percent of revenue
• One or two years of declining SDE
• Books that require significant reconstruction or unclear add-backs
• Short remaining lease (under three years) on a critical location
• Industry headwinds, regulatory uncertainty, or technology disruption
• Key employee dependency without documented succession
• Cash income that cannot be documented or verified

The skill is matching your business honestly against these factors and selecting a multiple that reflects your actual position in the range, not your hopes for it. Sellers who anchor on the high end without justification get long-listed properties that do not sell. Sellers who underprice their business leave money on the table.

Notice what this example does not do. It does not pick a multiple from thin air or use the high end of the range without justification. Each adjustment is tied to a specific factor a buyer or lender would identify. If a buyer disagrees with one of the adjustments, the conversation is about that specific factor, not about the overall number. That is what defensible valuation looks like.

Method 2: Discounted cash flow (income approach)

The discounted cash flow method is what people mean when they say a business is "really" worth a certain amount, separate from what the market happens to be paying right now. DCF is the most theoretically rigorous valuation method, and it is also the most sensitive to its assumptions. Change the growth rate by two percentage points or the discount rate by three percentage points, and the answer can move by 40 to 60 percent.

The full DCF formula looks intimidating. The intuition is straightforward.

In words: estimate the cash the business will produce each year for the next five to ten years, divide each year's cash by (1 plus the discount rate) raised to that year's power, sum the discounted cash flows, then add a "terminal value" that captures everything beyond the projection period. The sum is the value of the business today.

The three inputs that matter

Cash flow projections. Most DCF models for small businesses start with current-year SDE or EBITDA and project growth at a defensible rate. For a stable business, that growth rate is often 2 to 4 percent (roughly inflation). For a growing business, it might be 5 to 15 percent, but only with strong supporting evidence: signed contracts, growing recurring revenue base, expansion into a clearly attractive market. Buyers will not pay for hypothetical growth they have to create themselves.

The discount rate. The discount rate represents the return a buyer would demand to take the risk of owning the business. For public companies, this is calculated using the Capital Asset Pricing Model and typically lands at 8 to 12 percent. For small private businesses, the rate is dramatically higher because small businesses carry significantly more risk: less diversified revenue, more owner dependency, less liquidity, more business cycle exposure. The typical discount rate for a small business DCF is 18 to 30 percent.

Terminal value. Cash flows after the projection period are captured in a terminal value, calculated using one of two methods. The perpetuity growth method assumes cash flows continue forever at a modest growth rate, typically the long-term GDP growth rate. The exit multiple method assumes the business is sold at the end of the projection period at a market-derived multiple. For small business DCF, the exit multiple method is more common and more defensible.

Why DCF rarely wins the argument

For a typical small business sale, DCF rarely sets the asking price. Buyers do not pay theoretical values. They pay market values plus or minus some negotiation room. A seller who insists on a DCF-based asking price ends up listed for 18 months without offers.

Where DCF does matter:

• As a sanity check. If your SDE-multiple valuation is dramatically higher than DCF, something is wrong with the multiple selection. If DCF is dramatically higher than SDE-multiple, the market is undervaluing the cash flow projection, which usually means buyers do not believe the growth assumptions.
• For growth businesses. When a business has high growth and low historical earnings, SDE multiples penalize the business unfairly. DCF can produce a more accurate value by giving credit for projected growth, though buyers will still discount aggressively.
• For strategic acquirers. When the buyer is a strategic acquirer (a competitor or supplier rather than an individual operator), DCF math closer to their cost of capital becomes relevant. Strategic buyers sometimes pay 30 to 50 percent more than financial buyers because the post-acquisition cash flows look different to them.

Method 3: The IRS Excess Earnings Method

The Excess Earnings Method was created by the IRS in 1920 to compensate wineries and distilleries for goodwill lost during Prohibition. It was formalized in IRS Revenue Ruling 68-609 in 1968, where the IRS itself described it as a "formula approach" to be used "only if there is no better basis available for making the determination."

Despite that disclaimer, the method has stuck around for sixty years because it solves a specific problem: how do you value a business when its goodwill is significant but its market multiples are unreliable? The method shows up most often in three contexts: estate and gift tax valuations, divorce proceedings, and professional practices where the goodwill is substantial but transaction data is thin.

How the method works

The Excess Earnings Method splits the business into two value components.

1. Tangible asset value. The fair market value of the business's tangible assets (equipment, inventory, accounts receivable, real estate if owned). This is usually appraised separately.
2. Intangible (goodwill) value. The capitalized value of "excess earnings," which is the amount by which actual earnings exceed a fair return on those tangible assets.

The formula sequence:

The IRS-specified rates

Revenue Ruling 68-609 actually specifies rates to use, which is unusual for IRS guidance:

• For low-risk businesses with stable earnings: 8% return on tangibles, 15% capitalization rate on excess earnings
• For high-risk businesses: 10% return on tangibles, 20% capitalization rate on excess earnings

The IRS notes these are examples, not requirements. In practice, appraisers often use different rates based on the specific business and current market conditions, but the rates in the Ruling provide a defensible default.

Why EEM rarely sets the price in a sale

If the Excess Earnings Method produces such a high value, why does the business not sell for that amount? Because buyers are not paying for theoretical value; they are paying for what the market currently bears for a business of this type and risk profile.

The Excess Earnings Method is widely viewed by valuation professionals as inflating values for small businesses with significant goodwill. It works as expected in three specific situations:

• Estate and gift tax valuations, where the goal is to defend a value to the IRS and the method itself is sanctioned by IRS guidance.
• Divorce proceedings, where state courts often use the method to value business interests for asset division, though some states (notably Florida) reject it because it does not separate personal goodwill from enterprise goodwill.
• Professional practices like accounting firms, law practices, and medical offices, where transaction data is thin and goodwill is the dominant value driver.

For an ordinary owner-operated small business going to market, the Excess Earnings Method is unlikely to be the method that determines the asking price. It is useful to understand because your CPA may mention it during exit planning conversations, because an SBA appraiser may include it as one of several methods in a formal valuation, and because it provides an upper-bound check on whether your business has theoretical value the market is currently not paying for.

Triangulating the three methods

You now have three numbers for the same business. Which one do you use?

For the coffee roaster example, the three methods produced:

The defensible range is not the average of the three numbers. It is the zone where the methods that matter most for this kind of business overlap, with the methods that matter less serving as outside boundaries.

For this coffee roaster, the SDE multiple method is the primary indicator because the business is owner-operated, under $3 million in revenue, and will most likely sell to an individual buyer using SBA financing. The DCF and Excess Earnings results show that there is theoretical value above the market multiple, but only a strategic buyer would pay for that theoretical value. The realistic asking price sits a bit above the SDE multiple value to capture some upside negotiation room, but not as high as the DCF or EEM results.

What the gap between methods tells you

When the three methods produce wildly different numbers, the gap tells you something specific.

What buyers actually do

This is the part of the process that most seller-side guides skip. Knowing how buyers think about valuation changes how you set your asking price.

A serious buyer evaluating your business does some version of the following sequence.

Step one: pull comparable transactions for the industry. They look at DealStats, PeerComps, or BizBuySell to see what businesses of similar size and type have actually sold for in the past two to three years. This gives them a baseline multiple range.

Step two: calculate their own SDE. They take your tax returns and your CIM, recalculate SDE from scratch using their own add-back rules (which are usually closer to lender standards than seller standards), and arrive at a number that may differ from yours. We covered this in detail in our SDE guide.

Step three: apply their multiple to their SDE. They take their adjusted SDE and apply a multiple from the lower end of the industry range, then negotiate upward based on what they see in diligence.

Step four: confirm the deal finances. They run the math through SBA underwriting standards to confirm the deal can be financed. If their offer price does not produce a debt service coverage ratio of at least 1.25, they reduce the offer until it does.

Step five: discount for whatever they do not like. Customer concentration, owner dependency, short lease, missing documentation, key employee risk. Every issue they find reduces the offer.

Notice what is not in that sequence: DCF. Most individual buyers do not run a DCF model, because they know their offer is constrained by what they can finance and what comparable transactions support. DCF is what they would pay if they had unlimited capital and were optimizing for pure economic value. Real buyers are constrained by financing, which means they pay market multiples, not theoretical DCF values.

Common valuation mistakes

Five mistakes account for most of the valuation problems sellers run into. Each one is preventable.

Mistake 1: Using the high end of every range

The valuation conversation has multiple ranges: the industry multiple range, the discount rate range, the growth rate range. Sellers often anchor on the high end of every range simultaneously, which compounds into an asking price that is 50 to 100 percent above what the market will support. Pick honest values for each input. The compound effect of conservative inputs is what produces credible valuations.

Mistake 2: Using net income instead of SDE

Net income on the tax return is artificially small for most small businesses because owners structure their finances to minimize taxes. Applying an industry multiple to net income produces a wildly low number. The right starting point is SDE, calculated with documented add-backs.

Mistake 3: Ignoring the financing test

An asking price that cannot be financed is not a price; it is a wish. Every valuation should be cross-checked against SBA underwriting math. If your asking price does not support a DSCR of 1.25 with a reasonable buyer salary, the deal will not close at that price regardless of what the methods say.

Mistake 4: Treating valuation as a one-time exercise

Sellers calculate their valuation once, then list at that price for 12 to 18 months. The market moves. SBA interest rates change. Comparable transactions get added to databases. Your business's own performance evolves. Revalue your business quarterly if you are within two years of selling. The asking price should track current conditions.

Mistake 5: Hiring an appraiser before knowing what you need

A formal appraisal costs $2,000 to $10,000 for a small business and longer documents run higher. Some sellers commission an appraisal before they know whether they need one, then anchor on the appraised value through 12 months of failed negotiation. A self-prepared valuation is usually sufficient to set an asking price. Commission a formal appraisal only when one is required, typically for estate planning, divorce, or as part of a specific transaction.

Common questions about valuation