You've probably wondered about your company's worth as a business owner. But how do you accurately determine its value?
Understanding how to value a business can improve your future planning, even if you're not currently considering selling your company.
There are several business valuation methods, each with advantages and limitations.
The asset-based method calculates value based on net asset value. However, it may not be ideal for businesses with healthy cash flow.
The most common method is the market approach. It compares your company with similar ones that have recently sold. But, it can be challenging if comparable businesses are inadequate.
Lastly, the income method focuses on projected earnings, which is best for companies with high projected earnings and low risk. However, due to earnings unpredictability, it is often not suitable for most small to midsize businesses.
Let's explore how to value a small to midsize business by examining different methods and types of business valuations.
2 Types of Business Valuations
Before exploring how to value a business, it's important to identify your specific needs. Your valuation requirements will vary based on these needs.
Generally, there are two types of business valuation: legal and fair market.
Legal Valuation
Legal valuation is crucial in legal scenarios like divorce proceedings, partnership disputes, or other litigations where accurately determining a business's value is crucial.
Certified appraisers or professionals specialized in legal valuations usually conduct this type of valuation.
The process involves using quantitative methods to analyze the business's financial performance over the last five to eight years. However, unlike other valuation methods, legal valuations do not consider the financial benefits of owning the business.
Legal valuations can be relatively costly. It typically ranges between $10,000 and $20,000 for businesses generating revenue between $1 million and $25 million.
Fair Market Valuation
A fair market valuation is valuable in business situations, like tax planning, investor attraction, or exit strategy preparation.
Unlike legal valuations, fair market valuations take a qualitative approach. This approach focuses on how potential buyers perceive the business.
Typically conducted by advisors or business brokers, these valuations utilize their expertise in assessing market conditions and business potential.
The cost of fair market valuations varies significantly based on factors like the company's size, the valuation's complexity, and the desired timeline.
While some firms may offer valuation services at no cost to establish a relationship, others may charge fees ranging from $3,000 to $30,000. This fee structure helps reduce risks, particularly if the business fails to sell following the valuation.
3 Methods For Business Valuations
Knowing how to assess the value of a business accurately is crucial for making informed decisions. There are three main methods for business valuations. Let's break down each:
Asset-Based Method
The Asset-Based Method calculates a business's value by assessing its assets and liabilities. It subtracts the value of liabilities from assets to determine the business's worth. For overall value, analysts consider assets like machinery, vehicles, and inventory listed on the balance sheet.
However, this method is generally unsuitable for businesses with healthy cash flow since it doesn't consider future earnings potential. Businesses where asset value significantly determines overall worth commonly use this method.
Book Value Method
The Book Value Method determines a company's value by subtracting its total liabilities from its total assets, as documented in its balance sheet. This straightforward approach measures the company's net worth based on its tangible assets. However, it's essential to recognize its limitations.
While it provides a concrete figure, the Book Value Method may only partially capture the actual economic value of assets. This is especially true for intangible ones such as patents, copyrights, or brand value.
Liquidation Value Method
The Liquidation Value Method estimates a company's worth by assuming it sells off its assets and settles its liabilities in a liquidation scenario.
This method is particularly relevant in troubled companies or bankruptcy cases, where the business's financial health requires a quick sale of assets. In such scenarios, the company's assets are valued based on their fair market value in a forced sale, which often results in lower valuations due to the urgency of the sale.
Replacement Cost Method
The Replacement Cost Method determines a company's value by evaluating the expense of replacing its assets at prevailing market rates. This approach is particularly relevant in industries reliant on substantial physical assets like manufacturing or real estate, where asset value significantly affects the company's overall value.
Market Approach
The Market Approach is one of the most commonly used methods for valuing small to midsize businesses. It involves examining data on what similar companies within the same industry have sold for successfully, considering factors like size, revenue, profitability, and other characteristics.
Analysts derive an industry multiple by comparing these with the company's attributes. They then apply this multiple to the business's adjusted earnings to estimate a baseline valuation.
However, these multiples can vary based on your company's perceived risk and desirability within its industry. Various factors contribute to determining the company's risk profile, including its age, growth trajectory, scale, management requirements, revenue predictability, capital intensity, customer concentration, and margins.
Comparable Company Analysis (CCA)
Analysts usually use the Comparable Company Analysis (CCA) method when market prices are not readily available.
This approach involves comparing key financial metrics, like the target company's price-to-earnings (P/E) ratio and price-to-book (P/B) ratio, against those of similar publicly traded firms.
Analysts can closely analyze these metrics to assess the target company's relative valuation within its industry context.
Precedent Transactions Analysis (PTA)
Precedent Transactions Analysis (PTA) is a business valuation method focusing on past acquisition deals within the same industry.
It closely examines the valuation multiples paid by acquirers for similar companies in previous transactions.
By thoroughly examining these historical deals, analysts gain valuable insights into how the market assesses comparable companies in merger or acquisition situations.
Market Capitalization
Market Capitalization is a straightforward method for determining a company's worth based on the market.
It calculates a company's value by multiplying its total number of outstanding shares by the present stock price. This method reflects the overall market valuation of the company's equity.
Market Capitalization offers a clear and easily understandable assessment of its worth based on current market performance and investors' collective perceptions.
Income Method
The Income Method uses the business's historical, present, and anticipated cash flows, considering the risk of underperformance. It's especially suitable for companies with optimistic future earnings projections and minimal risk of falling short.
However, this method may not be the most appropriate choice for most small to midsize businesses (SMBs). It relies on theoretical assumptions and projections, which may not align with the unpredictable nature of SMB operations.
Discounted Cash Flow (DCF) Analysis
A commonly used method for valuing small to midsize businesses is the Discounted Cash Flow (DCF) Analysis. It involves projecting a company's future cash flows and discounting them back to their present value using a predetermined discount rate.
The DCF method assesses the current worth of a company's anticipated cash flows by factoring in the time value of money. This makes it highly favored among investors and analysts for evaluating growth potential and profitability.
Capitalization of Earnings
The Capitalization of Earnings method offers a practical approach. It estimates a company's value by dividing its anticipated annual earnings by a predetermined capitalization rate. This rate reflects the expected rate of return investors would seek from the investment.
This method is particularly beneficial for stable and mature companies with predictable earnings. It provides a straightforward means of assessing a company's worth based on its income-generating potential.
Income Multiplier Method
In the Income Multiplier Method, a company's value is determined using a multiple of its earnings or cash flows.
Industries frequently use this method where valuations often represent a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) or Earnings Before Interest and Taxes (EBIT).
Dividend Discount Model (DDM)
The Dividend Discount Model (DDM) focuses on companies that pay dividends to their shareholders. It calculates a company's worth by discounting its future dividend payments to their present-day value.
Assuming constant dividend growth over time, the DDM provides a valuation based on the expected trajectory of future dividends.
Earnings-based Valuation
Valuation methods based on earnings use various metrics connected to a company's profits to assess its value.
For example, the Price/Earnings (P/E) ratio compares a company's stock price with its earnings per share, giving insight into the market's perception of its earnings potential. Additionally, analysts often use earnings-based valuation metrics like Earnings Per Share (EPS) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Take charge of your success - Learn how to value a business!
Taking charge of your success begins with understanding the complexities of valuing a business. It is important to recognize that business valuation is not a one-size-fits-all process. At its core, a business's value depends on the price someone is willing to offer for it, a value that varies significantly from person to person.
Leveraging valuations as a foundation allows for more discussions and negotiations with potential buyers instead of relying on guesswork.
Similarly, for those venturing into purchasing a business, understanding valuations ensures confidence in independently estimating its value, regardless of the asking price set by owners or business brokers.
Request Your Business Valuation from Sunbelt Texas
Whether you operate a small or medium-sized business, the valuation experts at Sunbelt Texas are here to assist you in evaluating your company's value. Reach out to us today to discover more about our business valuation services!
FAQs
What are the common methods of business valuations?
Common methods include:
The income approach (discounted cash flow method, capitalization of earnings method).
Market approach (comparable company analysis, precedent transactions).
Asset-based approach (asset accumulation method, adjusted net asset method).
How do I choose the right valuation method for my business?
The method selection relies on variables like the business's nature, industry, financial performance, and the intent behind the valuation. It is advisable to consult with a professional valuation expert.
Can I perform a business valuation on my own?
Yes, conducting a basic valuation using online tools or templates is possible. However, obtaining an accurate valuation requires expertise in finance, accounting, and valuation methodologies. Hiring a professional valuator is recommended for complex valuations.