The best practices to follow when you need a valuation fast
Whether you are a buyer or seller, you need to have a clear idea of what the item in question is worth. When it comes to business valuation, a seller may need to determine the value of their business quickly to decide whether a potential offer is viable, while a buyer may want to perform a quick appraisal prior to making an offer. In either scenario, both parties should understand the trade-offs between accuracy and speed in the valuation process. To learn how to value a business quickly without increasing your risk, you need to understand the benefits and shortfalls of each available option.
In this blog post, we explain some commonly used methods for quick business valuation, along with their inherent pitfalls, while providing some useful tips for obtaining an accurate valuation as quickly as possible.
The importance of a quick business valuation
Learning how to value a business accurately is extremely important since business owners need a precise company valuation any time they pursue a loan, court investors, project future growth, offer stock shares, or sell the business. Since these scenarios are likely to come up occasionally, and sometimes unexpectedly, many business owners go through the valuation process at regular intervals to avoid surprises down the road.
Each business valuation method, including revenue, earnings, and asset-based options, takes time to complete, depending on the accuracy and readiness of financial records and other business documents. In some instances, a valuation is needed more quickly. Circumstances that might call for a quick business valuation include:
● An unexpected or unplanned sale of the business
● A sudden need to secure additional equity financing
● Dissolution of a partnership
● Securing a line of credit to cover unexpected expenses
● Merger with another business or entity
● Seeking new insurance coverage
Overview of rapid valuation methods for businesses
While any business valuation method can also be used for quick valuation, the practices that tend to work best in these scenarios are those that require fewer complex calculations, yet produce a fair and accurate result. Depending on the circumstances and industry norms, the following methods can be used to meet these quick valuation criteria:
● Market capitalization methods that obtain a valuation by multiplying the current stock share price by the total number of shares outstanding.
● An earnings multiplier approach that uses earnings per share (EPS) or earnings before interest, taxes, depreciation, and amortization (EBITDA) to determine a valuation based on business performance-based operating profitability.
● Revenue-based valuation methods that use top line income data to form a basis of comparison with other similar companies in the same industry.
Additional valuation methods can also be used, but these three common practices allow a valuation figure to be generated quickly, without extensive research or auditing. While the first two methods can apply to companies that have issued shares of stock to the public, EBITDA and revenue-based methods also work well for small, private companies and pre-IPO startups.
Step-by-step guide to using the market capitalization method
Simply multiplying the share price by the number of shares outstanding might sound extremely easy, but there are a few important nuances and pitfalls to keep in mind as you learn how to value a business quickly using the market capitalization method.
Stock prices can be extremely volatile, so the first obstacle is determining when to calculate the market value and how much variation to account for. For example, a buyer may value the company (and make an offer) based on a peak stock price, then see the value tumble if a bear market (or news of the impending sale) causes a sudden drop in the stock price.
To complete a business valuation effectively using the market capitalization method, you should follow these basic steps:
- Determine the latest closing (or average) stock share price.
- Determine the number of diluted shares outstanding, including those tied up in options, warrants, and other mezzanine financing instruments like convertible debts.
- Calculate the valuation figure based on:
Market Cap = Share Price × Total Diluted Shares Outstanding
The earnings multiplier approach for swift valuation
An earnings multiplier valuation is ideal for quick valuation since it compares your business to other companies in the same industry based on published data alone. One common earnings multiplier is known as the price-to-earnings (P/E) ratio, which is simply the stock price of a publicly traded company divided by EPS. This method provides a barometer for earning potential relative to the current stock price.
Comparing P/E ratios within the same industry enables a quick assessment of relative valuation. A higher P/E ratio may indicate that investors expect higher future growth potential from a company, while a lower P/E ratio might suggest a company is undervalued relative to its earnings. The earnings multiplier approach allows you to benchmark the values of similar companies based on this common metric.
Similarly, an EBITDA multiple provides a simple valuation based on earnings that can be used for both private businesses as well as publicly traded ones. An EBITDA multiple can be calculated as EBITDA divided by enterprise value. EBITDA multiples vary by industry, but can provide a quick and meaningful valuation that is based on company profitability.
Tips for revenue-based valuation
As the name implies, revenue-based valuation uses annual sales figures to determine the valuation. By comparing revenue to similar businesses, an accurate estimate of the value can be obtained. For example, if shoe repair shop #1 did $100,000 in sales last year and was valued at $1 million, shoe repair shop #2 would be worth $2 million based on $200,000 in annual sales. A revenue-based valuation can be performed effectively and quickly when reliable financial data and industry benchmarks are readily available.
Obviously, this method discounts some important metrics, including company overhead, operating expenses, cost of goods (COGS), and debt which can eat into profit margins and impact the bottom line. However, a rapid valuation based on revenue alone can be completed almost instantly. Additional tips for performing a successful revenue-based valuation include:
● Study industry dynamics and choose companies for comparison wisely.
● Verify the accuracy of revenue data.
● Analyze historical revenue and projected growth.
● Review customer data to understand the customer lifespan and repeat sales.
Quick valuation accuracy and pitfalls
By their nature, rapid business valuation methods sacrifice detail for the sake of speed. Many of the common business valuation mistakes and pitfalls experienced overall, including lack of due diligence, calculation errors, and underestimating risk factors, are exacerbated when time is of the essence. Given the quick turnaround, the accuracy of data used for quick valuations is of the highest importance.
One of the best ways to overcome the inherent challenges of a quick business valuation is by consulting with a professional business appraiser. These specialists work independently to prepare a business valuation based on financial information, industry comparisons, and in-person reviews. An experienced business appraiser can help you balance speed and accuracy to obtain an optimized result.
In conclusion
In today’s dynamic business landscape, the ability to quickly and accurately assess business valuation is essential, whether you are a buyer or seller. Quick valuations enable timely decision-making regarding potential offers or investments, but it’s crucial to balance speed with accuracy. Understanding the trade-offs involved in different valuation methods and being aware of common pitfalls can help you avoid costly errors. By leveraging industry benchmarks, verifying data accuracy, and seeking professional advice when needed, businesses can navigate the complexities of quick valuations effectively.