Understanding the true value of a business is crucial to making informed decisions and maximizing returns, especially in M&A transactions, where considerations differ significantly between M&A buy-side and sell-side perspectives. Accurately determining a company’s fair market value can provide valuable insights into its current financial health, potential growth opportunities, and areas for improvement.
What is valuation in business? What is the business valuation process? What business valuation approaches exist? And how do you calculate business valuation? Find out in this article.
What is a business valuation?
Business valuation is a process of determining the economic value of the company, giving owners an objective estimate of the business worth.
During the valuation process, all areas of the business are analyzed and all of the company’s assets are assessed. The valuation of a business embraces both tangible and intangible assets, as well as the analysis of the company’s management, its future earnings prospects, and current capital structure.
Business valuation is performed for various reasons, including sale, taxation, establishing partner ownership, and divorce proceedings or as a part of a divestiture strategy. Additionally, regularly performed valuations can help identify ways to improve business operations.
Note: Learn how to perform M&A financial modeling in our dedicated article.
Why is a valuation of a business important?
Business valuation analysis allows owners to define the true value of a business, which is beneficial in many regards. Not only does it help to determine the current market value and position of the company, but it also highlights the areas that need attention and offers new opportunities for growth.
Business valuation is also often used for tax reporting. This is because the Internal Revenue Service (IRS) requires businesses to be valued based on their fair market value.
Additionally, business valuation is crucial for strategic planning, providing insights that help guide future decisions. It can also play a significant role in financial reporting, ensuring transparency and accountability.
In general, calculating a business’s valuation helps to put a business owner in a strong position when:
- Selling a business
- Attracting investors
- Seeking a merger or acquisition of another business
- Planning for business expansion
- Adding shareholders
- Establishing the percentage of partner ownership
- Considering an exit strategy
- Planning for tax reporting
- Securing financing or taking a business loan
- Resolving legal disputes, such as in divorce proceedings or shareholder disagreements
Read our comprehensive guide on how to finance the acquisition of a business if you’re interested in learning more about the available options and strategies.
Steps in the business valuation process
Drawing on our own experience, a typical business valuation process includes the following steps:
Look for a qualified business valuation professional through reputable sources such as professional associations (e.g., American Society of Appraisers), online directories, referrals from financial advisors, or legal professionals. Ensure they have relevant experience and credentials.
Discuss the purpose of the valuation, whether it’s for a sale, merger, tax reporting, or another reason. This helps in defining the scope of work and ensures the valuation is tailored to your needs. Sign a formal engagement letter outlining the terms, conditions, and objectives of the valuation. This agreement should specify the services to be provided, timelines, fees, and other important details.
Determine the type of value being assessed. Is it the market price between a willing buyer and seller, or the investment value to the current owner? The basis of value is often set by regulations, legal requirements, or contracts and guides the valuation process.
Define the premise of value based on the valuation’s purpose and basis. This could be based on the going concern premise, assuming continued business operations, or a liquidation premise, assuming the sale of assets. In M&A transactions, the premise of value might be higher due to anticipated benefits from the acquisition.
Gather all relevant financial documents, contracts, agreements, leases, loans, and other commitments affecting future profitability. The client should compile this information for the appraiser. The valuation expert also gathers comparative data on similar companies.
Review the company’s history, ownership structure, and past financial performance to assess how it compares to similar businesses. This comparison helps establish performance metrics and the company’s market position.
Estimate future value by evaluating the company’s current strategy and historical performance. Project future revenues, expenses, taxes, capital needs, cost of capital, and market share. Compare these projections to similar companies and assess the viability of the business plan.
Choose the appropriate valuation method based on the valuation’s purpose, basis, premise, and available data. The main valuation techniques are the market, income, and asset-based approaches. Often, multiple methods are used.
Apply discounts for private companies, such as a marketability discount for the difficulty in selling ownership stakes quickly and a minority discount for shareholders lacking control over key decisions. In some cases, apply a key person discount if the company’s value heavily relies on a single individual.
Draft a detailed valuation report that includes the valuation purpose, methodology, analysis, and final value estimate. Review the report for accuracy, completeness, and compliance with relevant standards and guidelines. Present the valuation report to the stakeholders, explaining the findings and answering any questions.
Business valuation approaches
There are three main approaches for business valuation: market-based, income-based, and asset-based. Every approach offers separate company valuation methods or techniques. Let’s first see what each approach implies.
Market-based approach
The market-based approach is a common way to define the current value of a business. It implies comparison. Simply put, this approach compares a company to similar businesses in the same industry. These similar businesses are usually called “comps”. To find the market value of a company, consider comps that have been recently sold and compare their price to your business.
For example, if a comparable company was sold for $6 billion, the present value of your company is probably similar.
The market approach provides a relative value for a company, and when combined with other approaches, it can give a more accurate picture of the company’s value.
The market valuation usually involves the following business valuation models:
- Public company comparable
- Precedent transaction analysis
Income-based approach
The income-based approach is often used for the business valuation of operating companies.
It implies measuring the current business value of projected future cash flows generated by the particular business. In other words, you define the value of a business by estimating the expected net income through a certain period of time and recalculating the current cash flow.
This approach is considered to provide an intrinsic value and is usually performed when a company is seeking a merger or acquisition of another company.
The income-based approach usually involves these methods of business valuation:
- Discounted cash flow (DCF) method
- Capitalization of earnings
Asset-based approach
The asset-based or adjusted net asset method is widely used for a business valuation of companies that have investments.
As the name suggests, according to asset-based valuation, the present value of a company is the difference between a fair market value (FMV) of the net assets of a company and its liabilities.
This approach is especially useful when valuing real estate, such as a new construction or commercial property.
An asset-based approach to business valuation usually implies the following firm valuation methods:
- Book value
- Liquidation value
6 common business valuation techniques
Now, let’s see how each business valuation method is calculated and explore the relevant business valuation formulas.
1. Public company comparable
The public company comparable method presupposes evaluating a particular company based on the market value of its competitors.
The comparison is possible only with public companies that have all their metrics publicly available. Often, it might be difficult to reach direct compatibility, since the majority of public companies would be larger.
How to calculate?
There’s no specific business valuation formula for this method since the resultant value is relative. However, these are the recommended steps to perform an accurate valuation with a public company comparable valuation:
- Choose the appropriate list of comparable public companies.
- Define the metrics and multiplies you want to use.
- Calculate the metrics and multiples for all the comparables from the list.
- Apply the 25th or 75th percentile multiples median from the comparables to your company to get its implied equity and enterprise value.
2. Precedent transaction analysis
The precedent transaction analysis presupposes defining the value of your business based on the comparison of the recent M&A transactions in similar industries.
This method is commonly used when trying to value a business as a part of a merger or acquisition deal and is usually performed by private equity, investment banking, or corporate development analysts.
How to calculate?
To define the value of your business with the help of precedent transaction analysis, follow these steps:
- Explore the relevant transactions that took place recently.
- Analyze the most appropriate deals.
- Define the range of valuation multiples.
- Apply the multiples to your business.
- Note the results.
3. Discounted cash flow method
The discounted cash flow analysis is often considered a golden standard of business valuations.
According to the discounted cash flow analysis, the company’s present value is based on the projected future cash flows over a certain period (typically five years).
This model is built on the theory that the value of a business is equal to the present value of its future profits plus the present value of the residual cash flows.
How to calculate?
The basic formula for the calculation of the business valuation via the discounted cash flow model is the following:
DCF = CFt / (1 +r)t
Where,
- “CFt” stands for the cash flow for period “t”
- “r” stands for the discount rate that has given the riskiness of cash flows
- “t” stands for the life of the valued asset
However, the DCF calculation is a much more difficult process that requires professional expertise. Often, extra software tools are used, such as a business valuation calculator
4. Capitalization of earnings
The capitalization of earnings method calculates the business value based on its cash flow, return on investment (ROI), and expected value.
The most important part of this model is the assumption that your profits, growth, and finances will be stable for a long period of time. Thus, this model is best suited for businesses expecting stable cash flows for years.
How to calculate?
The capitalization of earnings method is usually calculated using the formula:
Value of a business = Net Operating Income / Capitalization Rate
5. Book value
The book value method of valuation is also often called the going concern method. It’s used to value a company that plans to continue its operations after the valuation process.
The book value method reviews the company’s balance sheet, lists its total net asset value, and subtracts its liabilities.
How to calculate?
There’s no difficult formula for business valuation via the book value method. The book value of the company is calculated by defining the company’s total assets and then subtracting its total liabilities.
6. Liquidation value
The liquidation method is considered the most straightforward. It’s used to value the businesses that are looking to be sold.
This method presents the value of a company if all of its assets are liquidated and liabilities are immediately paid off. Notably, with this method, the business value is usually lower than with other corporate valuation methods.
How to calculate?
To calculate the liquidation value of the business, simply remove the value of all assets and liabilities from the financial report.
Choosing the appropriate valuation method
Use the table below as a guide to choosing the most appropriate valuation method for your business’s size, industry, and objectives.
4 main factors for business valuation
This is what you, as a business owner, should be aware of when considering business valuation services:
Tangible assets are physical assets that can be seen and touched. These include property, equipment, inventory, and machinery. Tangible assets are relatively easy to quantify and are typically included in the valuation of a business. For example, the value of a manufacturing company may be heavily influenced by the value of its machinery and equipment.
Intangible assets are non-physical assets that contribute to the value of a business but are not easily quantifiable. Examples of intangible assets include trademarks, patents, copyrights, brand names, customer relationships, and goodwill. These assets can significantly enhance the business’s fair market value, especially in industries where intellectual property and brand recognition play a critical role.
Liabilities represent the obligations and debts owed by the business. These may include loans, mortgages, accounts payable, accrued expenses, and other financial obligations. When valuing a business, it’s essential to account for all liabilities to determine the company’s net worth or equity value. Failure to accurately assess liabilities can result in an inflated valuation and misrepresentation of the business’s financial health.
Financial statements, including the balance sheet, income statement, and cash flow statement, provide valuable information about the business’s revenue, profits, expenses, and liabilities. Investors, lenders, and potential buyers rely on financial statements to assess the company’s financial health and make informed decisions about valuation and investment.
Key takeaways
- The business valuation is equally important for businesses that are considering a sale and those that plan to continue operations.
- A company’s valuation provides business owners with an objective estimate of their business’s worth.
- There are three main approaches to business valuation: market-based, income-based, and asset-based. Each approach implies a few different methods.
- The most common business valuation techniques are comparable company analysis, precedent transaction analysis, discounted cash flow method, capitalization of earnings, book value, and liquidation value.
Understanding and correctly applying different business valuation methods is crucial for accurately assessing a company’s worth, informing strategic decisions, attracting investors or buyers, and ensuring fair and transparent transactions, ultimately maximizing value and facilitating long-term success.
