For many business owners, their business is their largest asset, so it’s normal to want to understand its worth. The problem is that it’s not always as straightforward as applying a simple calculation. Valuing a business is subjective, and two people could see the same set of company financials and arrive at vastly different valuations.
There are many reasons a business owner may need to know its current value, including if they want to sell the business and retire, or to obtain debt or equity financing. No matter the reason, valuing your business depends on many different factors.
Let’s review some of the most common business valuation techniques.
Sometimes referred to as the cost-based methods, this is the most basic way to value a business. Essentially, you are taking the value of the business’ hard assets and subtracting the debts.
Assets-based valuations can be done one of two ways:
- A going concern asset-based approach will list the business’ net balance sheet value of its assets and subtract the value of its liabilities
- A liquidation asset-based approach will determine the net cash that would be received if all of the business’ assets were sold, and its liabilities paid off
While straightforward, this method often renders the lowest value for the company because it does not account for “goodwill”. Because of this, one of the two methods described below may yield a higher valuation.
Earning value approaches
This method follows the idea that the business’ true value lies in its ability to produce wealth in the future; essentially the buyer is estimating what your future cash flow is worth to them today.
The valuator determines an expected level of future cash flow using the business’ past earnings (taking into account unusual expenses or revenue), and multiplies this number by a capitalization factor. The capitalization factor reflects the expected rate of return the buyer should expect in the future.
Market value approaches
In this method, the valuator will establish the value of a business by comparing it to other similar businesses (“comparables”) that have recently sold. Of course, there must be a reasonable number of very similar comps that have sold within your industry to be able to use this method, which is not always the case with privately held companies.
It’s important to focus on more than one facet, such as industry, when looking at comparables. For example, a small ecommerce company cannot base its value off of Amazon, just as an internet startup cannot base its value off of what Facebook is trading at.
The earning value approaches are the most popular business valuation method used, although some combination of approaches may be a better fit. The first step in determining the true value is to hire a professional. As part of our process, we offer a detailed valuation / transaction analysis at no cost to owners considering their options for the business. If you’d like to learn more, contact our team.