What Is a Business Valuation?Author: Daniel Mather
Put simply, a business valuation is a way of determining the fair market value of a company — that is, how much money a company is worth.
To determine the present value of a business, one needs to look at all the different areas of a business. Analysts can examine a series of factors in their business valuation, such as the company market value, past and projected cash flow, or the value of all its assets added up.
Let’s take a look at some of the different business valuation methods. But first…
Why would you need a business valuation?
There are several situations where you may need to determine the worth of a company and where a business valuation will be called for.
Before selling your company
One rather obvious instance is if you own a company which you’re planning on selling. To establish a target price for the sale, a business valuation will be needed.
For this kind of deal, you may find it necessary to hire a specialized accountant (or even a team) to conduct the valuation process. In the US, that’ll mean a public accountant with an ABV (Accredited in Business Valuation) certification.
When buying — or buying into — a business
The business valuation process is a key part of the due diligence you do before acquiring a company. As when selling a business, this will often be a task for a certified accountant.
In a similar situation, as an investor planning on buying shares of a company, you’ll need to establish the value of a business to know whether the business’s valuation corresponds with reality. Whether a company’s shares are undervalued or overvalued will play into your decision to buy or not to.
Before going public
Let’s say you’re taking your company public. You’ll need to determine the business value so as to set an initial share price for the public offering. And guess what — here, too, a company valuation is in order.
For taxation purposes
Another common case is when the IRS (and equivalent bodies across the world) find it necessary to conduct a valuation in order to determine the fair market value of the business, and hence the amount of tax it should pay.
During a divorce
If someone who owns a company is going through a divorce, they will likely have to declare their business’s worth, since this will count as part of their net worth and be included in the alimony calculation.
As you can see, there are plenty of reasons why you might need a business valuation. But there are many more: for insurance purposes, before a company owner leaves, in order to secure financing, as part of establishing a succession plan, for state planning, and so on.
Top 7 business valuation methods
Now we get to the fun part. What kind of business valuations methods can we use for calculating the value of a business? As you’ve probably guessed, there are quite a few valuation methods; what type of business valuation method you use depends on your objective:
- The asset based valuation method
- The market value valuation method
- The book value method
- The earnings valuation method
- The discounted cash flow valuation method
- The times revenue method
- The historical earnings methods
1. The asset based valuation method
Also known as the cost approach, the asset based valuation method calculates the combined sale value of a business.
That means you estimate the overall selling price of all a company’s liquid assets, or its liquidation value. The liquidation value includes tangible assets such as real estate, stocks, cash, and equipment, as well as intangible assets such as intellectual property (trademarks, copyrights, patents, customer relationships, etc.)
Because most businesses are worth more than the sum of their assets, the liquidation value provides a rather limited understanding, but it can be useful for asset-intensive businesses or financially distressed companies, where bankruptcy is followed by an auction of its assets.
2. The market value valuation method
Also known as the market capitalization method, this is one of the most common valuation methods for companies. It essentially tells you to multiply the price of a company’s stock for the number of its shares.
The market capitalization is popular with investors who want to calculate the economic value of an enterprise. But it also has its flaws. A company’s share price can be inflated due to investor perception, and thus fail to represent the actual enterprise value of a company.
3. The book value method
The book value valuation method takes the balance sheet of a company to ascertain its economic value by looking at assets minus liabilities.
Although an important business valuation method, it has a similar limitation to the asset based valuation method, since it fails to account for intangibles such as market goodwill, potential, and key business relationships.
4. The earnings valuation method
One of the different company valuation methods based on a multiplier, the earnings multiplier valuation looks at the expected net income, or profit, of a company’s balance sheet relative to another factor such as the expected cash flow from an investment at current interest rates.
One of the most common multiplier methods is the profit-to-earnings valuation method. This method, more commonly known as the P/E ratio, looks at the price of a company’s shares in relation to its earnings per share (EPS).
Although the P/E ratio in itself doesn’t tell us a lot about the present value of a business, it can be used to compare the business with other comparable companies in the same industry.
5. The discounted cash flow valuation method
Similar to the earnings valuation methods, the discounted cash flow analysis (or DCF valuation method) calculates the expected net cash flows of a business for a certain period of time. The discounted cash flow analysis then adjusts these future cash flows to factor in inflation.
Discounted cash flows are a useful business valuation for determining the current market value of an investment by projecting how much the business is expected to generate in future.
6. The times revenue method
With this method, we first look at the revenue a business generates over a certain period (usually 12 months). We then divide the selling value of the company by that value.
Essentially, the time revenue method tells us how many years of earnings will be necessary to recoup the purchase value of a business, which can be useful when comparing it to similar businesses.
7. The historical earnings method
As the name tells us, this kind of valuation looks back into a company’s past financials — this includes elements such as a company’s ability to pay debt, its capitalization of earnings, and capitalization of gross earnings.
By looking at a company’s past performance and using that to estimate the amount of goodwill the market has towards it, the company’s valuation gives us an understanding that goes beyond its intrinsic value and is often more connected to real-world future profits.
As you see, there are quite a few methods of business valuation by which you can calculate enterprise value. Which methods are used will depend on your needs — as seen above, there are any number of reasons for wanting to conduct a business valuation.
Most often, the true valuation of a company is outside the realm of precise calculation, but by combining several of the above methods, the analyst can get a close-enough appraisal from which to make their decisions.