- Knowing a business’s valuation is important to both short-and long-term strategies.
- There are three key business valuation approaches: market-based valuation, asset-based valuation and income-based valuation.
- Understanding your business’s valuation is an important part of knowing your business’s financials as a whole.
When it comes to running a successful company, it's critical to know your business inside and out. This includes knowing how to calculate your company's valuation, which helps you understand your prospects for shareholder growth and even for sale. Business valuation is used to help business owners, investors, interested parties and other stakeholders understand your business's worth and how it may develop down the line.
You can determine the value of a business in a few different ways, some of which are better approaches for certain companies than for others. It's important to understand why you want to value your business, how to value a business and the methods to do so; particularly, you’ll want to know about market-, asset- and income-based approaches. Once you know these common methods, you can better understand what’s best for you, as well as identify the benefits of each.
First: Why is business valuation important?
It's important to know your business's valuation for wide-ranging reasons, including how you tackle both short- and long-term goals. Some of the reasons to know your business valuation include:
- Attracting investors
- Succession planning
- Selling your business
- Planning for expansion
- Developing an exit strategy
- Considering mergers and acquisitions
- Planning for taxes and other reporting
Each of these situations will apply to different businesses at different points in their life cycles. Regardless, when you know your business valuation now and track how it grows, you can make strategic decisions that benefit your company, as well as your personal financials.
Market-based valuation is among the common approaches to business valuation. This method compares a business to similar businesses in the same industry. These “comparables,” or more commonly, “comps,” have been sold relatively recently.
This approach involves comparison: look at comps to gain a sense of their valuations, in order to determine your own worth. For instance, if a comparable company is valued at $5 million, your business may be in the same valuation ballpark. The accuracy of this method depends on the similarities between your products, balance sheet, revenue and growth rate. Businesses are often under- or over-valued, so pinning your valuation to other comparable companies is not always fully accurate.
As a result, combining the market-based valuation approach with another method to gain a more accurate picture of your company’s value, can be a strategic approach.
Another method is the asset-based valuation, which involves totaling your business’s assets and subtracting its liabilities. The resultant number is sometimes called the “book value.”
A widely used method within the asset-based valuation approach is called the “adjusted net asset” method. In this approach, the estimated value of your company is the difference between the fair market value of your total assets and your business’s liability. An important thing to note is that the asset-based valuation method suits some businesses better than others. This valuation is particularly suited to businesses that hold investments or real estate since it emphasizes the value of both, and you may also want to explore this method if you've been generating losses.
Along with the adjusted net asset approach, variations of the asset-based valuation process are important to understand to get a sense of the asset-based valuation approach as a whole.
The liquidation value approach is among the most straightforward. This method simply refers to the value of a company if all of its assets were liquidated and its liabilities paid outright. The resultant number is the company’s value.
Going concern valuation
The going concern value is another approach. It’s specifically used to value companies that are expected to continue operating, in contrast to liquidation value, which companies often use when they consider closing. The going concern value encompasses intangible assets (such as intellectual property, customer base, etc.) that the liquidation value does not. This likely results in a higher final value.
A third approach is the income-based business valuation method (sometimes called the "earnings-based method"). This is often a good choice for companies with profitable operations.
Your profit and loss (P&L, or income statement) is the key to the income-based valuation method. Here, you value your business by estimating your expected net income through a certain time period and recalculating your cash flow in terms of today’s dollar values. This is also known as the “present value.”
There are different ways to approach income-based valuation.
Discounted cash flow (DCF) method
The discounted cash flow approach to business valuation calculates your cash flow over a selected period of time (often, five years). This method relies on forecasting and a practical approach. To use this approach, you’ll need to obtain or prepare a forecast of net cash flows for the chosen time period, calculate your “terminal” or “residual” value, determine your appropriate discount rate and know your capitalization rate.
Capitalization of earnings method
The capitalization of earnings methods is another way to figure out how to value a business. The most important part of the capitalization of earnings approach is the assumption that your profits, finances and growth will be steady from year to year. You determine this steady earnings number, then discount it using an appropriate capitalization rate to find a present value.
The capitalization of earnings method is well-suited to businesses expected to have stable cash flows, whereas the DCF method is better suited to businesses whose cash flows may fluctuate.
Build your business
A company can be valued several ways, and the best valuation approach for a business depends on a number of factors, including its size, projected growth and more. The more resources you have, the better you’ll be at not only choosing the valuation method that’s best for your specific business but also understanding the numbers and figures that go into determining valuation. Consider looking at additional educational business material, such as Business Plan Definition: A Breakdown.