What Is Business Valuation and How Do You Calculate It?

what is business valuation
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Whether you’re considering selling your company or looking for new investors, there may come a point when you need to assess its economic worth. Put simply, you’ll need a business valuation. There are many methods of business valuation, and it’s important to understand how the process works, even if you’re hiring an expert. Here, we’ll break down the business valuation process with an example, including the formula for calculating it.

What Is a Business Valuation?

A business valuation, often known as a company valuation, is the process of estimating a company’s economic value. During the valuation process, all aspects of a corporation are examined to evaluate its value as well as the value of its departments or units.

A business valuation can be used to evaluate the fair value of a corporation for a variety of purposes, including determining selling value, establishing partner ownership, taxation, and even divorce processes. Owners frequently seek objective estimates of the value of their businesses from professional business assessors.

The Fundamentals of Business Valuation

In corporate finance, the question of business value is regularly discussed. A business valuation is often performed when a company wishes to sell all or a portion of its operations, combine with, or buy another company. The process of establishing the present worth of a business using objective metrics and evaluating all areas of the business is known as business valuation.

A business valuation may include an examination of the company’s management, financial structure, future earnings projections, or asset market worth. Evaluators, firms, and sectors all employ different tools for valuation. An examination of financial records, discounting cash flow models, and comparable company comparisons are common techniques for business appraisal.

Tax reporting requires valuation as well. The Internal Revenue Service (IRS) mandates that a company be valued at its fair market value. Some tax-related actions, such as the sale, acquisition, or giving of a company’s shares, will be taxed based on valuation. 

Determining a company’s fair worth is both an art and a science; there are various formal models that may be employed, but selecting the right one and subsequently, the necessary inputs can be fairly subjective.

Business Valuation Methods

There are different methods of business valuation. Each method varies from the other, but in any case, you’ll need to consult with a business evaluation professional to get the most out of whichever method you choose. 

#1. Market Value Valuation Method

First, the market value business valuation method is likely the most subjective technique for determining the worth of a company. This method calculates the value of your company by comparing it to similar firms that have recently sold.

Of course, this strategy is only applicable to companies that have access to substantial market data about their competitors. In this regard, the market value method is a particularly tough approach for sole proprietors, for example, because comparative data on the sale of similar enterprises is difficult to come by (as sole proprietorships are individually owned).

Having said that, because this small business valuation method is very imprecise, the value of your firm will ultimately be determined through negotiation, especially if you’re selling your business or looking for an investor. Although you may be able to persuade a buyer of your company’s worth based on intangible characteristics, this technique is unlikely to be effective in attracting investors.

Still, this valuation method is a solid starting point for determining how much your company is worth, but you’ll probably want to bring another, more measured approach to the negotiation table.

#2. Asset-Based Valuation Method

Then, to assess the value of your firm, you could employ an asset-based business valuation method. As the name implies, this method takes into account your company’s total net asset worth less the value of its total liabilities as shown on its balance sheet.

There are two approaches to asset-based business valuation methods:

Going Concern

Companies that intend to continue functioning (i.e., not be liquidated) and not sell any of their assets immediately should adopt the going-concern approach to asset-based company valuation. This calculation takes into consideration the company’s current total equity, or assets minus liabilities.

Value of Liquidation

The liquidation value asset-based method, on the other hand, is based on the assumption that the business is done and its assets will be liquidated. The value in this scenario is based on the net cash that would exist if the business were dissolved and the assets were sold. Under this strategy, the value of a company’s assets is likely to be lower than typical, as liquidation value is sometimes substantially lower than fair market value.

Finally, the liquidation value asset-based strategy operates with a sense of urgency that other methods do not always account for.

#3. ROI-Based Technique of Valuation

An ROI-based business valuation approach determines the value of your company based on its earnings and the potential return on investment (ROI) that an investor could obtain for investing in your firm.

Here’s an illustration: If you pitch your company to a group of investors for equity financing, they will begin with a valuation percentage of 100%. If you ask for $250,000 in exchange for 25% of your company, you’re using the ROI-based method to evaluate the value of your company when you present this offer to investors. To explain, divide the sum by the percentage offered, for example, $250,000 divided by 0.25 to get your rapid business valuation—in this case, $1 million.

The ROI approach makes sense from a practical standpoint—an investor wants to know what their return on investment will be before they invest. But, a “good” ROI is ultimately determined by the market, which is why business valuation is so subjective.

Also, with this strategy, you will frequently want additional material to persuade an investor or buyer of the outcome. How long will it take for an investor or buyer to recoup their initial investment?

After that, how does my return appear when I compare my part of the predicted net income to my investment?

Is it a reasonable estimate? Ambitious? Conservative?

Does it entice me to invest in this company?

All of these inquiries will help to shape an ROI-based business appraisal.

#4. The Discounted Cash Flow (DCF) Valuation Method

Although the three approaches discussed above are commonly considered the most frequent, they are not the only ones available. In fact, while the ROI-based and market value-based methods are very subjective, some other methodologies use more of your company’s financial facts to determine its worth.

For example, the discounted cash flow valuation method, often known as the income approach, evaluates a company based on its future cash flow, adjusted (or discounted) to present value.

If your profits are not likely to be steady in the future, the DCF approach can be especially valuable. However, as seen in the CFI company valuation example below, the DCF method necessitates much detail and meticulous calculations:

#5. Capitalization of Earnings Valuation Method

After that, the capitalization of the earnings valuation approach forecasts a company’s future profitability based on cash flow, yearly ROI, and predicted value.

Unlike the DCF method, this strategy works best for stable enterprises because the formula assumes that computations for a specific time period would continue. This strategy based a company’s current value on its ability to be profitable in the future.

#6. Multiples of Earnings Valuation Method

The multiple of earnings valuation approach, like the capitalization of earnings valuation method, evaluates the value of a corporation by its future profits potential.

Having said that, this small business valuation method, also known as the time revenue method, determines a company’s maximum worth by multiplying its current sales by a factor. Multipliers differ depending on the industry, the economic climate, and other considerations.

#7. Book Value Appraisal Technique

Finally, the book value approach uses your balance sheet to determine the value of your company at any given point in time.

With this method, your balance sheet is utilized to compute the value of your equity—or total assets minus total liabilities—and this figure represents the worth of your business.

If your company has modest profits but valuable assets, the book value technique may be especially effective.

Formula For Calculating Business Valuation

Market capitalization is one of the most straightforward approaches for calculating business valuation. It is calculated by multiplying the current share price by the total number of shares outstanding.

The market capitalization approach is used to obtain the business valuation formula:

Market Capitalization = Current market price per share x the Total number of outstanding shares.

Example Of Business Valuation

XYZ Ltd. has 500,000 outstanding shares with a current share price of $ 500.00. The following information is used to determine the business value using the market capitalization method:

The current market price of the share multiplied by the number of outstanding shares equals 500,000 x $500 = $250,000,000.00 or $250 million.

The price is $250,000,000.

Importance of Business Valuation

A business valuation gives entrepreneurs many facts and data regarding their company’s genuine worth or value in terms of market competition and asset values. The data generated from business valuation methods assist business owners in determining how much to reinvest in the company and at what price they should sell the company to earn a profit. Furthermore, it assists potential purchasers or investors in estimating steady growth and revenue over the previous years. As a result, business valuation becomes an essential instrument for determining the future value of a company.

Accreditation In Business Valuation

Accredited in Business Valuation (ABV) is a professional title given to accountants such as CPAs that specialize in assessing the value of businesses in the United States. The American Institute of Certified Public Accountants (AICPA) oversees the ABV certification, which requires candidates to complete an application process, pass an exam, meet minimum Business Experience and Education requirements, and pay a credential fee (as of March 11, 2022, the annual fee for the ABV Credential was $380).

Retaining the ABV credential also necessitates meeting minimal benchmarks for work experience and lifetime learning. Qualified applicants are granted the privilege to use the ABV designation beside their names, which can boost career chances, professional reputation, and compensation. The Certified Business Valuator (CBV) credential is a professional designation for company valuation specialists in Canada. The Canadian Institute of Certified Business Valuators provides it (CICBV).

What Are The 4 Basic Ways Of Business Valuation?

The 4 basic methods of business valuation are:

  • Discounted Cash Flow (DCF) Analysis.
  • Multiples Method.
  • Market Valuation.
  • Comparable Transactions Method.

Can I Do My Own Business Valuation?

Because assessing the value of a small business is a sophisticated procedure, you may wish to engage a professional business broker or accountant who specializes in valuation rather than going it alone. You may, however, fully value your company using your own resources.

What Does Owning 1% Of A Company Mean?

If a company has 100 outstanding shares of stock and you own 1% of the company, it means you possess one share in the company. 

What Is The Rule Of Thumb For Valuing A Business?

The most typical rule of thumb is a percentage of annual sales, or, better yet, the previous 12 months of sales/revenues.

In Conclusion,

Business valuation can be used to evaluate the fair value of a corporation for a variety of purposes, including determining selling value, establishing partner ownership, taxation, and even divorce processes. While this process might not be easy, there are many methods by which you can conduct a business valuation. And, depending on the type of business, you might find some methods more advantageous than others. 

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