The Full Guide to Business Valuation: Determining Worth
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 Worth
To 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.)
Most of these reasons are fairly self-explanatory. For example, if you want to sell your business, you need to set a price. Similarly, if you’re going through a divorce, the court needs a value to determine the terms of your settlement.
Methods of Business Valuation
As 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.
This 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
Each of these approaches to valuation is dependent on a business’s ability to continue to produce income. If you’re the face of your business, the business will likely lose customers when you sell it. Appraisers know this, so they’ll discount the business value based on that potential loss of customers.
In 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.
The 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
Each of these methods uses slightly different valuation formulas, but the concept of assets minus liabilities remains. Depending on your business’s ownership structure, the asset based approach has its limitations. It’s generally best for corporations or LLCs because the assets are owned by an entity rather than a person.
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 Process
The 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.
Whether an appraiser uses the income, asset, or market-based approach, they’re measuring these three variables.
So, the primary differences in these approaches isn’t in what they measure but how they measure it. For example, asset and income-based methods both measure expected income. However, the asset-based method calculates the expected income that the business’s assets will produce. Alternatively, the income-based business valuation formula calculates expected income based on historic or predicted income.
The reason for these various approaches is that it’s impossible to avoid making some assumptions in the valuation process. Assumptions skew calculations because they’re based on subjective measures.
By taking multiple approaches to calculating the same thing, though, appraisers mitigate the effect of assumptions. This is why appraisers generally come up with multiple values for a business. Using some weighted average of the values from each approach, the appraiser determines a final value.
Improving Your Business Worth
Increasing the value of your business comes down to the same three variables we mentioned above. The more you can increase your expected income and reduce your risk, the more your business will be worth. Of course, that’s easier said than done.
Still, it’s a worthwhile exercise to think about what you can do to improve your business’s value. You’re likely already working on initiatives that will increase your income, but you should also consider risk.
For example, residential construction companies are in a highly cyclical industry: residential real estate. For them, business slows down significantly during an economic recession. However, if you found a way to diversify your construction services, you’d reduce the risk associated with your income. Even if you didn’t make more gross revenue, your business’s worth would increase.
In addition, you can improve your business’s worth by taking yourself out of the business. This is because if you’re the face of the business and you sell that business, the price will be discounted. After all, part of the reason your business produces income is the goodwill you’ve created over time. When you sell the company and leave, that goodwill goes away, which must be factored into the business valuation.
Just about every business owner can benefit from understanding the value of their business. At the very least, it’s part of being financially disciplined to know what you own and how much it’s worth.
As you can see, though, it takes some time to understand different business valuation formulas and methods. Deepen your knowledge by signing up to our email list to get the latest tips about business valuation delivered to your inbox.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.