Business valuation methods are ways by which the financial standing of a company can be determined. Determining the value of a business is not simple. It requires accounting for several factors within your business finances. Due to this complexity, many companies work with a professional to receive an objective, thorough evaluation of what their business is worth. We take look at the definition of business valuation, methods, and examples.
Business valuation definition
Business valuation can be defined as the process of determining the economic value of a company. It is how the story of a company, its history, brand, products, and markets is translated into dollars and cents.
All businesses have one thing in common – generating profits. Time frames, methods, and expectations may differ.
What is business valuation?
Business valuation can be described as the process of determining the economic value of a company. It is one of the market prospect ratios.
The business valuation process looks in depth at the operation, expenses, revenues, strategy, and risks of the business to arrive at assumptions for future earnings, time horizon, discount rates, and growth rates. Ultimately, the value of any business is the present value of expected future profits.
All business valuations are estimates. It is used by investors, owners, bankers, and creditors, as well as the Internal Revenue Service. The objective of the valuation, and who does the analysis, heavily influence the end result.
For example, investment bankers valuing a company to take it public want to justify the highest number possible, while accountants valuing a company for tax purposes want to arrive at the lowest number possible.
Business valuation is different from the pricing. Business valuation is based on the actual performance of the business. Pricing results from supply and demand; it incorporates market influences such as the overall direction of prices, other investors, and new information such as rumors and news.
Overall, business valuation is complicated considering the different methods available to evaluate your business and determine its economic worth. No single business evaluation method is necessarily better than another. Instead, the best assessment of your company will likely come from combining multiple business valuation methods.
Business valuation methods
- Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
- Net asset or book value
- Market capitalization
- Discounted cash flow (DCF)
- Enterprise value
- Market value or precedent transactions
- Liquidation value
Ultimately, different small business valuation methods will be preferable in different scenarios. The best approach will depend on why the valuation is needed, the size of your business, your industry, and other factors.
Even if you hire a professional to value your business, understanding how the process works are necessary. Therefore, we will have a look at some of the methods of business valuation:
Earnings before interest, taxes, depreciation, and amortization (EBITDA) method
What is the formula for calculating EBITDA?
EBITDA = net income + depreciation and amortization + interest expense + taxes
When examining earnings, financial analysts do not like to look at a company’s raw net income profitability as it is often manipulated in many ways by the conventions of accounting. Some can even distort the true picture.
First, the tax policies of a country seem like a distraction from the actual success of a company. They can vary across countries or time, even if nothing actually changes in the company’s operational capabilities. Second, net income subtracts interest payments to debt holders, making organizations look more or less successful based solely on their capital structures. Given these considerations, both are added back to arrive at earnings before interest and taxes (EBIT), or “operating earnings.”
Companies use depreciation and amortization accounts to expense the cost of the property, plants, equipment, or capital investments. Amortization is often used to expense the cost of software development or other intellectual property. In both instances, no actual money is spent on the expense.
In some ways, depreciation and amortization can make the earnings of a rapidly growing company look worse than a declining one. Large brands, like Apple and Amazon, are more susceptible to this distortion since they own several warehouses and factories that depreciate over time.
With an understanding of how to arrive at earnings before interest, taxes, depreciation, and amortization (EBITDA) for each company, it is easier to determine their value.
Example of EBITDA method
A housing company generates $200 million in revenue and incurs $80 million in production costs and $40 million in operating expenses. Depreciation and amortization expenses total $20 million, yielding an operating profit of $60 million. Interest expense is $10 million, which equals earnings before taxes of $50 million. With a 20% tax rate, net income equals $40 million after $10 million in taxes are subtracted from pretax income. If depreciation, amortization, interest, and taxes are added back to net income, EBITDA equals $80 million.
|Depreciation and amortization||+$20,000,000|
Net asset or book value method
What is the formula for calculating net asset or book value of a company?
Book value of a company = Total assets − Total liabilities
One of the most straightforward methods of valuing a company is calculating its net asset or book value. It is the fair market value of the business assets minus total liabilities on its balance sheet. This method calculates the value of your business at a given moment in time by looking at your balance sheet.
To calculate book value, start by subtracting the company’s liabilities from its assets to determine owners’ equity. Then exclude any intangible assets. The figure you are left with represents the value of any company’s tangible assets and your business’s worth.
Companies report their total assets and total liabilities on their balance sheets on a quarterly and annual basis. It is also available as shareholders’ equity on the balance sheet. The book value approach may be particularly useful if your business has low profits but valuable assets.
A company’s total assets cover all types of financial assets, including cash, short-term investments, and accounts receivable. Physical assets, such as inventory, property, plant, and equipment, are also part of total assets. Intangible assets, including brand names and intellectual property, can be part of total assets if they appear on financial statements. Total liabilities include debt obligations (including any debt financing), accounts payable, and deferred taxes.
Net asset value is useful as a lower limit for a valuation range, as it only measures a business’s tangible assets. Due to the simplicity of this method, it is often considered unreliable.
Example of net asset or book value method
Suppose a beauty Company has total assets of $70 million and total liabilities of $57 million. Then, the book valuation of the company is $13 million. If the company sold its assets and paid its liabilities, the business’s net worth would be $13 million.
Market capitalization or precedent transactions method
What is the formula for market capitalization?
Market capitalization = total number of shares x share price
Market capitalization is one of the simplest measures of a publicly-traded company’s value. It is calculated by multiplying the total number of shares by the current share price.
One of the shortcomings of market capitalization is that it only accounts for the value of equity. At the same time, most companies are financed by a combination of debt and equity. In this case, debt represents investments by banks or bond investors in the company’s future; these liabilities are paid back with interest over time. Equity represents shareholders who own stock in the company and hold a claim to future profits.
Example of market capitalization method
For example, Microsoft Inc. traded at $86.35 as of January 3, 2018, with a total number of shares outstanding of 7.715 billion; the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.
Discounted cash flow (DCF) method
What is the formula for calculating DCF?
DCF = [(cash flow) ÷ (1 + r)1] + [(cash flow) ÷ (1 + r)2] + [(cash flow) + (1 + r)n]
r = The discount rate
n = The number of years
The discounted cash flow or income approach method values a business using the cash inflows and outflows it is expected to generate in the future. These cash flows are discounted into a current value using a discount rate, which is an assumption about interest rates or a minimum rate of return assumed by the investor. It calculates the present value of future cash flows based on the discount rate and analysis period.
The discount rate reflects the potential risk of the business not meeting profit expectations. A higher discount rate results in a lower value, reflecting a greater risk posed by the business.
Variants of the discounted cash flow method use dividends, free cash flow, or other measures instead of earnings. The discounted cash flow method usually calculates the present value of five years of earnings adjusted for growth and future earnings beyond five years (known as terminal value)
It is performed by building a financial model in Excel and requires extensive details, analysis, estimates, and assumptions, often resulting in the most accurate valuation.
The DCF method allows the analyst to forecast value based on different scenarios and perform a sensitivity analysis. It can be particularly useful if your profits are not expected to remain consistent in the future as it reflects a company’s ability to generate liquid assets.
The challenge of the DCF method is that its accuracy relies on the terminal value, which can vary depending on the assumptions you make about future growth and discount rates.
Example of DCF method
Assuming a clothing company has the following information from its DCF analysis:
Current investment value = $49,000
Free cash flow = $900,000
Future projected investment returns = $1,750,000
Discount rate = 15%
Suppose the company is measuring the discounted cash flow over five years. In that case, it uses the formula and substitutes for n = 5, r = 0.15, and cash flow is equal to $900,000
DCF = [(cash flow) ÷ (1 + r)1] + [(cash flow) ÷ (1 + r)2] + [(cash flow) + (1 + r)n]
DCF = [($900,000) ÷ (1 + 0.15)1] + [($900,000) ÷ (1 + 0.15)2] + [($900,000) + (1 + 0.15)5]
DCF = ($782,609) + ($680,529) + ($447,450) = $1,910,558
The discounted cash flow shows that the company can expect the investment to provide them with a return that appears well above its initial projection of $1,750,000. Because of the high valuation of the future expected cash flow, the company may decide to go ahead with its investment.
Enterprise value (EV) method
What is the formula for calculating enterprise value?
Enterprise Value (EV) = MC + total liabilities − C
MC = Market capitalization; equal to the current stock price multiplied by the number of outstanding shares
Total liabilities = Equal to the sum of short-term and long-term debt
C = Cash and cash equivalents; the liquid assets of a company, but may not include marketable securities
The enterprise value method is a measure of a company’s total value. It includes the market capitalization of a company, short-term and long-term debt, and any cash on the company’s balance sheet. It is a popular metric used to value a company for a potential takeover.
The enterprise value is calculated by combining a company’s debt and equity and subtracting the cash amount not used to fund business operations.
Example of enterprise value method
Enterprise Value (EV) = MC + total liabilities – C
In 2016, Ford had a market capitalization of $44.8 billion, outstanding liabilities of $208.7 billion, and a cash balance of $15.9 billion. Using the EV formula
Ford’s enterprise value = $44.8 billion + $208.7 billion – $15.9 billion
Ford’s enterprise value = $237.6 billion
Market Value Method
The market value or precedent transactions method is perhaps the most subjective approach to measuring a business’s worth. This method determines the value of your business by comparing it to similar businesses that have sold using multiples like the price-to-earnings ratio (P/E).
The problem with using a relative method such as this is that it incorporates any errors the market makes in valuing comparable companies and in the overall direction of prices. As a result, a business might be under or overvalued. Nevertheless, it is a good preliminary approach to understanding what your business might be worth.
The market value method only works for businesses that can access sufficient market data on their competitors.
The market value method only works for businesses that can access sufficient market data on their competitors.
When assessing the market value of their business, owners establish what the business is worth based on similar businesses that have recently been sold.
Example of market value method
Suppose your business and its assets are worth about $15 million, but similar companies have been recently sold in the $10-million range. You may lose money on the sale if the market value method is used to value your business.
Liquidation value method
Liquidation value is the net cash a business will receive if its assets are liquidated, and liabilities are paid off today. This valuation method is based on the assumption that the business is finished and its assets will be liquidated. Therefore the business value is based on the net cash that would exist if the business was terminated and the assets were sold.
Assets in the liquidation value method include tangible assets like real estate, machinery, equipment, investment, etc., excluding the intangible assets.
With this approach, the value of a business’s assets will likely be lower than usual because liquidation value often amounts to much less than fair market value. Ultimately, the liquidation value method operates with a sort of urgency that other formulas don’t necessarily consider.
Example of liquidation value method
A shoe manufacturing company listed a market capitalization of $500 million on the stock exchange. The company also reported liabilities totalling $150 million and a book value of $400 million. The appraiser estimates the value of the company at $380 million in the auction market.
The liquidation value is $230 million, which is found by subtracting $150 million in liabilities from $380 million in auction value.
Additional business valuation methods
- Going concern
- Return on investment (ROI) based
- Capitalization of earnings
- Times revenue
- Earnings multiplier
- Comparable (Comps) analysis
This is by no means an exhaustive list of the business valuation methods in use today, as there are more methods.
Going concern method
This method is used for businesses that plan to continue operating and not immediately sell any of their assets. Itconsiders the business’s current total equity, that is, your assets minus liabilities.
Return on investment (ROI) based method
This method evaluates your company’s value based on your company’s profit and what kind of return on investment (ROI) an investor could receive for buying into your business.
Capitalization of earnings method
This method calculates a business’s future profitability based on its cash flow, the annual return on investment, and expected value. It bases a business’s current value on its ability to be profitable in the future.
Times revenue Method
Here, all revenues generated over a certain period of time are applied to a multiplier which depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.
Earnings multiplier method
This method adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current price-to-earnings (P/E) ratio to account for the current interest rate.
Comparable (Comps) analysis method
Comparable company analysis method also called trading multiples or peer group analysis or equity comps, or public market multiples is a relative valuation method in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method.
Reasons for performing a business valuation
- Tax and Succession Planning
- Buying a business and mergers.
- Selling a business
- Strategic planning
- Selling a share in a business
Business valuation to a company is an important exercise since it can help improve the company. However, due to its complexity, these calculations are not something businesses do every day. So when would you need a business valuation?
Ultimately, different small business valuation methods will be preferable in different scenarios. Generally, the best approach will depend on why the valuation is needed, the size of your business, your industry, and other factors. Here are some of the reasons why businesses need to perform a business valuation:
Tax and Succession Planning
Valuations determine estate and gift tax liabilities and have an important role in retirement planning. Tax and succession valuations follow IRS guidelines.
Buying a business and mergers
Business valuations are fundamental to negotiations for buying a business and mergers as they are used as benchmark values since sellers and buyers usually have diverse opinions on the worth of the business. A good business valuation will look at market conditions, potential income, and other similar concerns to ensure the business gets a proper valuation. They are also used to establish and update employee stock ownership plans (ESOPs)
Selling a business
When you want to sell your business or company to a third party, you must ensure you get what it is worth. The asking price should be attractive to prospective purchasers, but you should not be on the losing end. Thus, a business valuation solves that problem.
Business valuations are often central to solving disputes legally. During a court case such as settlements for legal damages, injury cases, divorce, partnership disputes, or where there is an issue with the value of the business, you may need to provide proof of your company’s worth so that in case of any damages, they are based on the actual worth of your business and not inflated figures estimated by a lawyer.
The in-depth analysis of a business valuation can help owners better understand the drivers of growth and profit. The true value of assets may not be shown with a depreciation schedule. If there has been no balance sheet adjustment for various possible changes, it may be risky. A current valuation of the business will give you good information that will help you make better business decisions.
Lenders and creditors often require valuations as a condition for financing. A business valuation is usually needed when you negotiate with banks or other potential investors for funding. Professional documentation of your company’s worth is usually required since it enhances your credibility with lenders.
Selling a share in a business
For business owners, proper business valuation enables you to know the worth of your shares and be ready when you want to sell them. These are used to benchmark buy-ins and buy-outs for partners and shareholders. Just like during the business sale, you ought to ensure no money is left on the table and that you get good value from your share.
Exit strategy planning
A valuation with annual updates will keep the business ready for unexpected and expected sales. It will also ensure that you have correct information on the company’s fair market value and prevent capital loss due to lack of clarity or inaccuracies.
In instances where there is a plan to sell a business, it is wise to come up with a base value for the company and then come up with a strategy to enhance the company’s profitability so as to increase its value as an exit strategy. Your business exit strategy needs to start early enough before the exit, addressing both involuntary and voluntary transfers.
What does business valuation tell you?
A business valuation can be useful when determining the fair value of a business, which is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. When a business trades on an exchange, buyers and sellers determine the market value of a stock or bond.
The concept of intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the business’s market price. That is where business valuation comes into play. Analysts do a business valuation to determine whether a company or asset is overvalued or undervalued by the market.
Limitations to the methods of business valuation
When deciding which business valuation method to use for your business for the first time, it is easy to become overwhelmed by the number of business valuation methods available. Some methods are fairly straightforward, while others are quite complicated.
Unfortunately, no one method is best suited for every situation. Each business is different, and each industry or sector has unique characteristics that may require multiple valuation methods. At the same time, different valuation methods will produce different values for the same company, which may lead analysts to employ the technique that provides the most favorable output.Last Updated on July 19, 2022 by Nansel Nanzip Bongdap
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