However, even if you have no pressing need for a business valuation, you should understand the process. After all, your business makes up some portion of your net worth. Knowing what exactly that portion is can help you plan for a variety of situations. Plus, by understanding how to approach business valuations, you’ll know when to pursue it. In this guide, we’ll review everything you need to know about business valuations.
What is Business Valuation?Business valuation is the process of determining the financial worth of a business or individual business unit. Due to the variety of factors that must be evaluated during a valuation, not all valuations follow the same process. For example, a public technology company will follow a different process than a regional restaurant chain. In other words, there’s no single, universal business valuation formula. Also, because a valuation must consider qualitative and quantitative measures, it’s both an art and a science. This means that some subjectivity and assumptions are inevitable. However, if you hire a certified business appraiser, you can eliminate as much subjectivity as possible. An appraiser will value your business based on many different measures. These measures might include an analysis of your balance sheet or a look back at similar businesses that sold. In fact, it’s common practice for an appraiser to use multiple business valuation methods.
How to Determine Business WorthTo determine your business’s worth, you need to hire an appraiser. You can do this through the American Society of Appraisers. You can determine your business’s worth by yourself if you want to. However, your valuation won’t be objective, so you won’t be able to use it in court or any other legal proceedings. That said, if you want to get an idea of your business’s worth, there are three ways to complete it. These are the asset-based, market-based, and income-based approaches. Your first step will be to select one or more of these business valuation methods. Which one you select is important because not all methods work for all businesses. For example, the market-based approach relies on there being available data on recent sales of similar businesses. If there’s no data, this approach can’t work. Once you’ve selected the right method, you’ll need to do the analysis and draw conclusions. More on that later.
Why Go Through The Process?There are various reasons you might want to have your business valued. Typically, you’ll need a business valuation to establish a value for:
- A purchase, sale or financing transaction
- Tax reporting
- General financial reporting
- Legal reasons (such as bankruptcy, disputes, divorces, etc.)
Methods of Business ValuationAs we mentioned earlier, there are three methods of business valuation: income, market, and asset-based. In this section we’ll review each of these methods in more detail. Remember that in many business valuations, appraisers generally use elements of multiple approaches to determine their final value.
Income BasedThis business valuation method seeks to value a company based on its expected income streams. The appraiser analyzes the business, determines its expected income, and discounts or multiplies that income by some rate. There are three common types of income-based valuation methods:
- Discounted cash flow
- Multiple of discretionary income
- Capitalization of earnings
Market BasedIn this approach, the appraiser analyzes previous sales of similar companies to determine the business’s value. These sales are called ‘comps’ or ‘comparables.’ As a concept, the market based approach to valuing a business is simple. However, making it work can be tricky. There must be enough recent sales of similar companies, otherwise there’s nothing to compare. Complicating matters is the fact that even if there are recent sales to analyze, the data is likely not available. Unlike public companies, private companies don’t have to disclose the financial details of business sales. All that said, if there are good comps, market based is a popular approach.
Asset BasedThe asset-based approach values a business by subtracting the business’s liabilities from its assets. In other words, this method subtracts what the business owes from what the business owns to determine value. Of course, it’s not quite as simple as it sounds. Within this approach, there are two different methods:
- Company asset accumulation
- Capitalized excess earnings
Which is the Best Method?Some valuation methods work better than others depending on the situation. However, there’s truly no universal “best” method. For example, the market based approach works for many public companies because there’s plenty of transaction data. For a private business, though, using a market based approach is often not feasible.
Breaking Down the Business Valuation ProcessThe variables and formulas in the business valuation process seem overwhelming, but the concepts are fairly simple. When you value a business, you’re valuing an investment. With any investment valuation, you must calculate three variables:
- The investment’s expected income.
- The risk level of the investment.
- The profit margin that a reasonable investor would expect.