how to value a business

How to Value a Business: Business Valuation Methods


Oct 28, 2021

Knowing how to determine the value of a company is beneficial whether you need a simple estimate or require accurate pricing information. Business owners need a precise company valuation in hand when seeking a loan, courting investors, projecting future growth, offering stock shares, or selling the business. With this guide on how to properly value a company, take a close look at three common methods of valuation before making the next steps toward your financial and business objectives. 

Asset-based value approach

With this valuation formula, simply add the value of all the assets owned by your business. Assets include inventory, equipment, supplies, real estate, and all other property in the company name. Then, subtract business liabilities, such as debts and unpaid expenses, from the total assets.

While this method for valuation of a company provides a basic estimate, it does not account for earnings, revenue, future growth, and other factors that influence value. If you need to determine the value of your business for an official purpose such as a sale, the asset-based approach will likely not provide the required level of accuracy. 

Cash flow approach

This approach estimates the value of a business based on its current and projected earnings. One of the most utilized methods of this approach is the discounted cash flow analysis. This complex valuation formula uses a projection of the company’s future cash flow (generally using the current cash flow as a starting point) and then discounts the value of those future cash flows back to today. The resulting value is the company’s net present value. 

While the discounted cash flow analysis is more accurate than the asset-based valuation method, it relies on discretionary factors such as the growth rate in future cash flow projections as well as the assumed discount rate, which will be different for every investor based on their perceived risk in the investment and their cost of capital.

Market value approach

The market value method strives to estimate the company’s fair value on the open market based on the recent sales prices of comparable companies in the same sector and geographic region. This approach uses benchmarks such as ratios or multiples from market comps to extrapolate an estimated value. Some of the most commonly used benchmarks include price/EBITDA, price/net income, price/revenue, and price/earnings. You might be familiar with the use of the market value approach to set residential property values; if you’re selling your home, for example, your real estate agent uses sales prices of similar homes in your neighborhood to guide pricing. 

The market value approach can provide valuable information when you plan to sell your business, face a tax or legal challenge, or have to navigate a conflict or buyout among partners. It relies on actual data, which enhances accuracy, and offers simple, easy-to-understand application with the availability of comparable transactions and businesses. Unlike the discounted cash flow analysis, it doesn’t depend on difficult cash flow projections or discretionary variables, which can have a large impact on the estimated value. However, finding recent and relevant comparable transactions and companies can be difficult even for experienced investors.

To calculate a company’s value using this method, you can look at public records, industry reports, and other sources to find a basis for comparison, focusing on companies that have similar:

  • Profit and revenue
  • Competitors
  • Service areas
  • Products or services
  • Industry reach
  • Size
  • Market capitalization
  • Debt
  • Earnings per share
  • Earnings before interest, taxes, depreciation, and amortization (EBITDA)

You can also look at the value of publicly traded companies that have similar characteristics; however, it can be difficult to find comparable companies because of the relatively large size of most public corporations. 

After identifying companies to use for market value comparison, you can use either the comparable company or precedent transactions calculation to estimate the value of your own business. The latter method works well if one of your comparison companies was valued or sold recently. In this case, apply the applicable benchmark from the transaction (such as price/revenue or price/EBITDA) as a ratio or multiple to the corresponding revenue, earnings, EBITDA, etc., of your company to arrive at the estimated value. In some sectors, comparables may be limited; determining the correct multiple may also require professional assistance. 

Advantages of professional business valuation

Even if you understand how to value a company, you can benefit from hiring a professional to appraise your business. These educated, experienced individuals know how to value businesses for financial and legal purposes. Most appraisers spend between 20 and 50 hours reviewing all aspects of the business before providing a comprehensive valuation report that covers income value, asset value, market competition, and other areas.

A seasoned business appraiser can accurately account for nonmonetary factors that affect the value of your company, such as geographic location and sector trends. An understanding of the business’s true open market value can place you in a better position for financing, investment, and sales negotiations. 

When hiring an appraiser, make sure the person has specific experience with your industry and type of business. For example, if your operations include real estate and equipment as well as the business itself, the valuation professional should be prepared to address all three areas in the official appraisal. Look for an appraiser who has earned accreditation from an industry organization such as the Institute of Business Appraisers or the National Association of Certified Valuation Analysts. 

References:

https://www.thehartford.com/business-insurance/strategy/selling-a-business/determining-market-value

https://www.business.com/articles/four-simple-steps-to-valuing-your-small-business/

https://corporatefinanceinstitute.com/resources/knowledge/valuation/price-earnings-ratio/

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html 

https://www.nerdwallet.com/article/small-business/how-to-value-a-small-business

https://www.entrepreneur.com/article/66442

https://corporatefinanceinstitute.com/resources/knowledge/valuation/market-approach-valuation/

https://www.inc.com/chirag-kulkarni/5-benefits-of-getting-a-business-valuation.html

https://corporatefinanceinstitute.com/resources/knowledge/valuation/valuation-methods/ http://edu.nacva.com/preread/2012BVTC/2012v1_FTT_Chapter_Six.pdf

  1. About the Author:

  2. About the Author:

    Jack Sadden is a Partner and co-founder of Valesco Industries and is primarily focused on various initiatives around strategic leadership of the firm, portfolio company performance, and investment origination. He is a graduate of the Florida State University School of Business and is a licensed Certified Public Accountant.

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