Business valuation is defined as the determination of the economic worth of a company. Businesses would be required to find the value of their business because of multiple reasons. Reasons can be any of the following:
- Either the business owner would be selling his/her company
- In the case of a share buyout transaction or adding shareholders
- When potential investors ask for the business value before deciding to invest in the firm
- At the time of merger or acquisition of a company
- In certain tax-related situations
- In the case of divorce proceedings
There are many methods used to determine business value. Some focus on the assets, some on market value, while some methods focus on the ROI (return on investment). It is on the business owner and the valuation professionals to select the best method for the company valuation. This depends on the business size, industry of operations, reason for valuation, and other factors.
Below we describe four key approaches used for determining the business worth:
Asset-based valuation method
This method is generally used in the case of acquisition transactions to determine the accurate purchase price of the business. In this method, the value is obtained by reducing the value of total liabilities from the total net asset value, as found in the balance sheet. The asset-based business valuation method has two approaches:
Going concern: This method is used when businesses plan to continue the operations and not sell any of their assets. Therefore, the current equity is considered in the calculation.
Liquidation value: This method is used when the business is to be liquidated. Therefore, the value is based on the net cash that is generated if all the assets are sold after terminating the business. However, this method will lead to a lower value of the business, since in the case of liquidation, the value of assets is lower than the actual market value.
Market value valuation method
It is a subjective approach of valuing a company by comparing it with the selling prices of recently sold similar businesses. In this method, there should be a sufficient number of recently sold businesses for a better comparison.
Financial statements of similar companies are reviewed and compared to the subject company, and market ratios related to stock prices are used. Although the value is generated in this approach, the actual business worth is based on the negotiation that the business has with the investor or buyer. This method can be used to get an initial idea of the business value; however, for an accurate value, a more calculative approach would work better.
Earnings-based valuation method
In this method, the business value is dependent on its ability to generate earnings in the future. This method is generally used when investors contemplate their decision to invest in your company. Before investment, investors must know the return on investment that they would receive.
The evaluator calculates future income based on past figures of expenses, sales, profits, and other important numbers and trends. Investors are also interested in knowing the time taken to recover the original investment amount, the expected additional amount generated from the business, and if any other business is generating more ROI compared to the subject company.
Discounted cash flow method
The discounted cash flow (DCF) method uses the financial data to obtain the value of a business. In this method, the future net cash flows are forecasted and adjusted to their present values to find out the money that the business assets will make in the future. It is a very detailed method and requires complicated calculations and analysis. It is based on several assumptions, develops different scenarios, and performs a sensitivity analysis to arrive at the business value.
The above-mentioned four methods are the most common approaches used by businesses for calculating business value. Besides, there are other approaches used, such as:
Capitalization of earnings valuation method:
This method uses the cash flow, expected value, and annual ROI to calculate a company’s future profitability. As it is based on the assumption that the business will continue to earn as the current times, it works best for stable businesses.
Multiples of earnings valuation method:
In this method, a multiplier is allocated to the current revenue of the business depending on the industry of operations, economic conditions, and other factors. Therefore, the business value is equal to earnings multiplied by the multiplier.
Any of these methods can be used to determine the business value depending on the industry scenario, economic situation, and existing state of your company. However, a key aspect is to hire a professional firm with the best minds in the industry to determine your business’s worth.
NR Doshi & Partners is one such firm, which helps you with the correct business valuation along with maintaining data security. We employ a valuation method as per the purpose of the valuation of the company and factor in all the business risks, debts, and other factors that can affect the value.