Business valuation refers to processes and procedures used to assess the economic value of a business or a person’s interest in a company. This indicator shows what’s the current financial standing of the company, an information that is useful for any current or potential investors. However, assessing a business’ worth can be much more complicated than you’d expect. For this reason, today we are going to look at several business valuation methods and approaches supported by examples.
Business Valuation Methods and Approaches to Help You Out
Before starting the analysis of various business valuation methods, it’s important to make a clarification. There is no single way to assess the entire worth of a business. The reason for this is that the valuation of a company can translate to so many things for so many different people. For example, a business owner may think that the value of his business is given by its connection to the community. At the same time, an investor will look at the historic income of it, not to mention the economic conditions that can change this definition. For this reason, there are formulas and techniques that focus on calculating one aspect of a business at a time.
#1. Asset Valuation
One of the most popular business valuation approaches is the asset one. From this perspective, a business consists of a set of assets and liabilities that construct the total value. This type of valuation relies on the economic principle of substitution, which asks what will it cost to set up a business just like this that brings the same benefits to the owners. As simple as it may seem, there are a couple of problems with this method:
- Deciding what assets and liabilities to include;
- Choosing a standard with which to measure their value;
- Determining what’s the worth of each asset and liability.
For instance, if you look at most balance sheets, you will see that people don’t include proprietary ways of doing business or internally developed products there. This is a shame since they are very important for the company.
#2. Historical Earnings Valuation
According to this business valuation method, the current value of a business is given by the:
- Capitalization of cash flow;
- Ability to repay debt;
- Gross income.
For example, if your company has some problems with paying bills, the overall value will drop. If it manages to maintain a positive cash flow and to repay any debt quickly, the business value will increase. All these factors are important for the historical earnings valuation.
#3. Relative or Comparable Valuation
The idea behind the third entry on our business valuation methods is to analyze a comparable company that got sold recently. Alternatively, check out other businesses like yours that have a known purchasing value. By comparing the value of the assets your business has to those owned by similar companies, you know what a reasonable price would be. One downside of this method is that you may end up comparing completely different assets, which leads to no relevant answers.
For example, accounting firms usually trade at 1 x their gross recurring fees, while office and home security businesses tend to trade at twice the monitoring revenue. It’s a good idea to ask at the annual industry conference and see what is the price for similar companies in your field.
#4. Future Maintainable Earnings Valuation
This method works only when you expect your profits to remain stable. Basically, the principle behind it is that the profitability of your business in the future triggers the value it has today. If you want to calculate the future maintainable earnings valuation for your business, you need to calculate the following:
- Gross profits;
Take all the numbers in the last three years and put them together. The result will show you what profits should you expect in the future and what’s the business value in the present.
#5. Discounted Cash Flow Valuation
Unlike the previous method, if you don’t expect the profits to be stable in the future, you should go for the discounted cash flow approach. This relies on taking the future net cash flows of the business and discounting them to the current values. The advantage of this method is that it considers inflation as well.
For example, let’s say an investor makes you choose between receiving $1000 now or $100 a year for 12 years. What would you choose? Maybe you think the second option would be better, but keep in mind that you need to consider inflation as well. If the inflation rate is 5% per year, the $100 you would receive each year in the future would equal $95 this year. After the 12 years, the $100 will value even less.
This clip illustrates the discounted cash flow valuation, together with other methods:
#6. Profit Multiplier/ Multiple of Discretionary Earnings Valuation
The last entry on our list of business valuation methods relies on setting the business value by multiplying the discretionary cash flow of a seller by a certain composite valuation multiple. The multiple is an element derived from other factors such as industry, business, owner preferences, market, etc.
For example, you use the business financial statements to assess the discretionary cash flow, the long-term business liabilities, and the working capital. Then, you analyze the overall financial and operational performance and you assign values to the key criteria. There are 14 criteria you need to consider:
- Business growth prospects;
- Customer concentration;
- Deal financing;
- Earnings track record;
- Ease of operation;
- Industry growth prospects;
- Market concentration;
- Nature of business;
- Product/service concentration.
The final step is to calculate the business’ worth now. Here you have a clip with a more in-depth explanation of this method:
To sum up, these are just a couple of the business valuation methods you can use. It’s best to choose two or three methods and to calculate them at the same time. In this way, you can get a more accurate image of what a business is worth now. Naturally, the result will depend on what area you are more interested in. In any case, approaching the issue from various angles helps with offering a complete response, compared to relying only on one method.