‘Business valuation? Why must I find the value of my business?’, will be the first question you will be asking yourself while reading this blog post.
Business valuation is calculating the economic and monetary value of a business. Business valuation is an essential requirement. Although there are professionals who can calculate it for you, business valuation can be calculated by yourself as well.
4 Reasons You Need Business Valuation
From a small business owner to a large scale company, there can be different reasons for having a business valuation.
Some reasons are stated below:
1. To sell or purchase a business
When you sell or buy a business, you need to know the worth of it. When you sell a business, you need to be certain that you get what it is worth. That’s where you need a business valuation.
Similarly, when you buy a business, you need to know its market position, potential income, fair market value, and other factors. So that it’s worth your investment.
So, don’t estimate the value of your business or pluck numbers from thin air. Hire a good chartered business evaluator to evaluate your business.
2. Making Well-Informed Decisions
A business owner or a company’s management may want a business appraisal to help decide the short-term and long-term strategies.
Therefore, having a business valuation will provide you with clear information that will help you make better business decisions.
3. Position Of Business In The Market
Knowing the position of your business in the industry and other similar businesses in the same industry can be used as a measure for performance evaluation and making strategies.
4. Entrance To The Capital
When you seek additional funds for business growth or save it from the crisis, the investor will want to see a full business valuation report. An investor would like to invest in a business with a high business value, and these values represent satisfied existing customers, good sales revenue, the higher current value of the company/business, high net cash and a good company’s management.
Business valuation is the first step in the process of securing a potential investor.
These are some of the general reasons for determining a business valuation. Ascertaining the market value of your business can help in areas like financing, taxation, liquidation, business sales, partner exits, public offerings, or dispute settlement such as divorce proceedings.
What is a business valuation?
A business valuation is a process and a set of procedures for determining the economic value of a business or company unit.
Business valuation can be used to determine the fair value of a business. An accurate business valuation can help in several situations.
Basics Of Business Valuation
Business valuation is a topic frequently discussed in corporate finance. It involves determining the current worth of a business, using different measures for evaluating all aspects of the business.
A business valuation also includes an analysis of the business’s discounted cash flow, the company’s capital structure, its future earnings prospects, or the market value of its assets.
Business valuation has a complex set of rules and it requires knowledge of valuation techniques, factors driving value in the industry, accounting standards and laws related to it, and a good understanding of the subject business or company.
The tools used for valuation may vary among evaluators, businesses, investors and industries. The most common approaches to business valuation include reviewing financial statements, earning approach models, and similar company comparison approaches.
So, this is all basic knowledge you must acquire to value a business.
How To Calculate Business Valuation?
To calculate a business valuation, you first need to identify the purpose of the valuation, and selecting the proper standard of value to use is critical to arriving at a fair, reasonable, and defensible value.
1. Determine The Basis Of Value
You first need to ascertain from whose perspective you are going to calculate business valuation. The basis of value refers to a consideration of the type of value being measured and the perspectives of the parties involved.
From whose perspective are you calculating business valuation? It can be from the point of view of a seller or buyer, an investor or any such other party to a transaction.
Sometimes, it can be difficult to determine the basis of value, because of the involvement of other factors, which can affect your decisions. That is why, the basis of value is mostly specified by law and regulations, agreement or contract, and may be used for valuation.
2. Determine The Premise Of Value
The premise of value can be determined by the purpose of the valuation and the basis of value.
Generally, it will fall in one of the following categories:
- Premise of a going concern
This premise assumes that the business will continue running normally using all of its assets to produce income. A company should always be considered a going concern unless there is a reason to believe that it will be going out of business soon.
- Orderly liquidation premise
This premise is quite the opposite of the “going concern” premise. In this valuation premise, the assumption is that the business assets will be operated or sold individually or as a group and the company will not continue operation.
- Forced sales premise
This premise refers to circumstances where you are under compulsion to sell and where, as a consequence, proper marketing is not possible and the buyer may not be able to undertake adequate due diligence.
The price obtained in these circumstances will depend upon the nature of the pressure on you and the reasons why proper marketing cannot be undertaken. Due to which the price obtainable in a forced sale cannot be realistically estimated.
The premise of value shall reflect the facts and circumstances underlying the asset to be valued as well as the purpose of business valuation. The premise will have an impact on the other factors of business valuation, such as valuation approaches, methodology, bases, and such other factors. The premise of value shall be mutually agreed upon by the chartered business valuator and the client for business valuation.
3.Gathering Data Relevant For Business Valuation
A list of some types of records and data required for business valuation:
- Financial records
A well-documented financial record allows appraisers to estimate future cash flow and profits. A company’s balance sheet and statement of profit and loss are the most important records to be maintained by any business. Financial records are also vital for calculating growth rates. Small businesses and startups with high growth prospects tend to receive higher valuations.
- Competitive advantage
It refers to the attribute that allows an organization to outperform its competitors. If this advantage can’t be maintained over time, the business’ valuation may fall low.
- Business assets
Intangible assets like patents, trademarks, and customer relations can boost business valuations. Although it may be hard to put a figure on these assets, their impact is significant.
Also, tangible assets like tools, business premises, plants and machinery need to be taken into account, and their value can be easily calculated. Depending on their volume and quality, tangible assets can boost business valuations.
- Size of business
Larger companies usually have higher valuations than their smaller counterparts because of greater income streams. Big businesses also tend to have easier access to capital in comparison to small businesses. They are also less impacted by the loss of key leaders.
All this data mentioned above, as well as contracts, customer/supplier agreements, leases, loans, and all other obligations that will impact future business profitability, will need to be analyzed. All these records should be compiled by the client and provided to business appraisers.
4. Review The Past Performance Of The Business
It is important to understand the company’s history, ownership structure, and past financial performance. This would allow us to compare the business valuation data of other companies in the same industry of similar maturity and size.
The performance of the subject company relative to similar companies is established by comparison to the similar companies’ dividend payout ratio, price to earnings ratios, price to book values, and price to free cash flow metrics.
5. Determine The Future Outlook Of The Business
The future outlook of a business is one of the most important factors. To determine the future value of a business, it’s necessary to first understand the company’s current strategy and performance. From this understanding, it’s possible to make estimates and forecasts of future revenues and expenses, market share, operating expenses, taxes, capital requirements, and cost of capital.
6. Determine The Valuation Approach
There are numerous business valuation methods. You’ll learn about several of these methods/approaches and you will have to choose one from the list given below:
1. Market Capitalization (Market Value)
Market capitalization is one of the simplest approaches to calculating business valuation. It refers to the total market value of a company’s outstanding shares of stock.
Market capitalization is an easy and quick method for estimating a business’s value by extrapolating what the market thinks it is worth for publicly traded companies. In such a situation, simply multiply the share price by the number of available shares.
The formula for calculating business valuation through the market capitalization rate is:
= Current market price of share * Total no. of outstanding shares
It can be noted that this method only works for publicly traded companies, where share values can be easily determined.
A major limitation of this method is that company valuation is subject to market fluctuations. If the share market declines due to its various external factors, the company’s market capitalization will decline despite its financial health.
Market capitalization relies on investor confidence and is therefore volatile and an unreliable measure of a company’s true value.
2. Earnings Multiplier
The earnings multiplier also called the price to earnings ratio, is a method used to compare a company’s current share price to its earnings per share (EPS). The earnings multiplier can be used to know about a company’s financial health. It is a valuation tool used to compare the share price of a company with that of similar companies.
The earnings multiplier can be used to compare several companies while making an investment decision. The earnings multiplier helps in calculating the return an investor will get against the invested amount by him. A company’s share price depends on various factors, especially the future market value, as it shows the scope and position of the company issuing the shares. It also shows the performance of a company compared to its competitors in the same industry.
The formula for earnings multiplier is:
= Price per share / Earning per share
Types Of Earning Multipliers
- Forward earning multiplier
The forward earning multiplier, or P/E ratio, divides the current share price of a company by the estimated future earnings per share of that company. For valuation, a forward P/E ratio is typically considered more relevant than a historical P/E ratio.
The formula for the forward P/E ratio is:
= Current share price/ estimated future earning per share
- Trailing earning multiplier
The trailing earnings multiplier, or P/E ratio, is calculated by dividing the current value of market or share price, by the earnings per share over 12 months. It estimates a company’s likely earnings per share for the next 12 months.
The earnings multiplier can be high or low due to the different reasons relating to its growth or share price.
3. Discounted Cash Flow Method
Discounted cash flow (DCF) is a method of business valuation used to estimate the value of an investment based on its expected future cash flow. Discounted Cash Flow analysis attempts to figure out the value of an investment in the present time, based on projections of how much money it will generate in the future.
The DCF method finds the present value of expected future cash flows using a discounted rate. Investors use this concept of the present value of money to determine whether the future cash flows of an investment or project are equal to or greater than the value of the initial investment.
The given opportunity can be considered only if the value you calculated through DCF is higher than or equal to the present cost of investment.
Calculation of DCF involves three basic steps :
- Forecast the expected cash flows from the investment.
- Select a discount rate, typically based on the cost of financing the investment or the opportunity cost presented by alternative investments.
- The final step is to discount the forecasted cash flows back to the present day, through a financial calculator, a spreadsheet, or a manual calculation.
The main limitation of the discounted cash flow method is that it requires many assumptions, which can result in less accuracy of the valuation.
4. Liquidation Value
Liquidation value is defined as the net value of a company’s physical assets if it were to go out of business and the assets had to be sold. This is the value of the company’s property, plant, and equipment. Intangible assets are not included in the company’s liquidation value.
There are generally four levels of valuation for business assets :
- Book value
- Liquidation value
- Salvage value
Each level of value provides a way to classify the aggregate value of assets. Liquidation value is especially important in the case of bankruptcy and the closure of a business or company. Liquidation value is generally lower than book value, but higher than salvage value.
Liquidation value is calculated by removing the value of all assets and liabilities of a company from its financial statement. The subtraction of liabilities from assets will result in the liquidation value.
5. Book Value
Book value, also known as net worth, is total assets minus total liabilities. It can also be defined as the value of shareholders’ equity of a business as shown on the balance sheet of the financial statement.
The formula of book value:
= Total assets – Total liabilities
A major issue with this method is that companies report the figure quarterly or annually. So, it is only after the reporting that an investor would know how the book value has changed over the months.
6. Times Revenue Method
The time’s revenue method is a business valuation method used to determine the maximum value of a business. The time’s revenue method is most appropriate for new companies or startups with earnings that are either non-existent or very volatile.
Business valuation is done by calculating a floor (the lowest price) and a ceiling (maximum price) that an individual is likely to pay. Through this, you can determine the value an individual is willing to pay to acquire the business.
The time’s revenue method is not always a reliable method of determining the value of a business. This is because revenue is different from profit. Therefore, an increase in revenue does not necessarily mean an increase in profits.
7. ROI valuation
ROI stands for return on investment and is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of different investment opportunities.
ROI is calculated by deducting the initial value of the investment from the final value of the investment, then dividing this new number by the cost of the investment, then finally, multiplying it by 100.
It is a key figure for businesses that want to know whether they are in the red or the black. ROI calculates, how much you have invested in the business and how much you can gain from the sale of the company. You need to know the current market value to make this calculation. Through ROI, you can assign an estimated value to your company/business if brought to sale.
A disadvantage of ROI is that it doesn’t account for how long an investment is held.
8. Relative valuation
This method of business valuation deals strictly with how much money your company would bring in if it were sold on the market.
With this valuation method, in this method, you compare every asset controlled by the business to similar assets. The value determined through this method gives you an estimated starting price for negotiations.
9. Asset based approach
This approach relies on calculating your business’s worth based on its assets. An asset-based valuation is a form of valuation in a business that focuses on the fair market value of the business.
The asset-based valuation approach is usually preferred because it provides flexibility to its users regarding the interpretation when you have to make a decision relating to assets or liabilities while considering the business valuation.
Methods in the asset-based valuation approach:
- Asset accumulation method: In the asset accumulation method, all the assets and liabilities of a business are compiled, and a value is assigned to each one. It has a very similar structure to that of a balance sheet.
- Excess earnings valuation: It is a combination of the income and asset valuation methods. It can also be used to value a company’s goodwill.
One of the limitations of the asset-based approach is that it disregards a company’s prospective earnings.
10. Comparable analysis value
A comparable analysis value method is a process used to evaluate the value of a company using the metrics of other businesses of similar size in the same industry. It is a relative form of valuation, unlike discounted cash flow (DCF) analysis, which is an intrinsic form of valuation.
The most common valuation measures used in the comparative analysis are:
- Enterprise value to sales (EV/S)
- Price to earnings (P/E)
- Price to book (P/B)
- Price to sales (P/S)
It helps in determining whether it is overvalued or undervalued. If the ratio calculated is high, then it is overvalued and if it is low, then the company is undervalued.
Business Assets And Internal Revenue Service (IRS) In Business Valuation
On July 27, 2006, the latest version of the IRS Business Valuation Standards.
Since valuation is important for tax reporting and business assets, standards have been set for IRS. According to the Internal Revenue Service (IRS), a business is required to be valued based on its fair market value. Taxation related events like the purchase or sale of shares, gifting shares or transferring shares to a successor, are ought to be taxed depending on its valuation.
Therefore, the valuation of business assets is linked with the standards of internal revenue service (IRS).
Should You Hire An Appraiser
If you are a small business owner or startup, you’ll likely be able to obtain all of the raw data you need to conduct your business valuation. While this may be feasible, you should determine your business valuation, only if it’s for your knowledge. If you need a business valuation for anything more than that or any reason mentioned above in the article, you should hire a professional business valuator.
But if we are talking about a company or a large scale business, one should hire a professional evaluator to get a valuation. As it would be really helpful for the future performance and future earnings.
Business valuation is thus an important aspect of your business. Which approach/method is the best? It depends on the purpose and other factors of valuation. Although the earning value approach is the most popular, one can use a combination of business valuation methods to identify and set a selling price.
But ultimately, valuations aren’t permanent. They can rise or fall depending on the circumstances. But as long as businesses deliver value to their customers and produce quality products, those efforts will eventually translate into a higher business valuation.
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