Business valuation is the process of determining the economic value of a company. The valuation of a business is used by many parties including investors, creditors, sellers, and buyers interested in a company. Accurately calculating value is both an art and a science. Below, we share three business valuation methods.
What Is Business Valuation?
Business valuation can be described as the process or the result of determining the economic value of a company. Performing business valuation means you are trying to determine the worth. The valuation of the business itself is the result of said process.
Like a home appraisal, someone is going to inspect and analyze a business in order to determine its value.
Once determined, the valuation will be used by parties to make economic decisions.
Below, you'll find a few examples of how a valuation could be used.
- Purchase or sale: You may want to purchase or sell a business. To do so, you'll want to know what it's worth so you don't overspend as a buyer or undersell as a seller.
- Secure financing: You may need debt or equity financing for expansion or cash liquidity. Potential investors will want to see that the business has sufficient worth.
- Adding shareholders: You may be adding shareholders (or one or more shareholders may ask for a buyout) to your business. In this case, the share value will need to be determined.
Business Valuation Methods
When determining the value of a company, there are many methods you'll come across. However, there are three approaches that are most commonly used to evaluate worth:
- Asset-based approaches
- Earning value approaches
- Market value approaches
Each approach has its considerations, and if you own a sole proprietorship, there are further factors to consider.
All three of these valuation methods also incorporate goodwill, the difference between a business's purchase price and its net identifiable assets/liabilities.
Essentially, an asset-based business valuation will total up all the investments in the company. Asset-based business valuations can be done in one of two ways:
- A going concern asset-based approach takes a look at the company's balance sheet, lists the business's total assets, and subtracts its total liabilities. This is also called book value.
- A liquidation asset-based approach determines the liquidation value, or the net cash that would be received if all assets were sold and liabilities paid off.
Imagine that Company A had $1,000 in assets and $300 in liabilities. If you were to use the going concern approach, you would subtract liabilities from assets to arrive at the company's value. In this case, the value would be $700.
Now imagine that you value Company A using the liquidation asset-based approach. In this scenario, you would take the company's assets and see what price you could receive if you sold everything. If your balance sheet shows $1,000 in assets, but you could only sell the assets for $900, then the value of the company would be $600 ($900 in assets minus $300 in liabilities).
Using the asset-based approach to value a sole proprietorship is more difficult. In a corporation, all assets are owned by the company and would normally be included in the sale of the business. Assets in a sole proprietorship, on the other hand, exist in the name of the owner, and separating business assets from personal ones can be difficult.
For instance, a sole proprietor in a lawn care business may own various pieces of lawn care equipment for both business and personal use. A potential purchaser of the business would need to sort out which assets the owner intends to sell as part of the business.
Earning Value Approaches
An earning value approach is based on the idea that a business's value lies in its ability to produce wealth in the future.
Capitalizing earnings determines an expected level of income for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and divides the annual income by a capitalization rate, also known as a "cap rate." If a business had an income of $1 million last year and the average cap rate in the industry is 5%, you could estimate value by dividing $1 million by 5%. The resulting value would be $20 million.
Another earning value method involves discounting future earnings instead of working with past earnings. To use this approach, you would first project the company's cash flows for five to 10 years. Then you would calculate what is called the "terminal value" of the company, which is the value of the company beyond the forecasted period of earnings.
To calculate the terminal value, you could use the Gordon Growth Model. Once you have the estimated cash flows and the terminal value, you would discount those values back to the current day using an appropriate discount rate for the company.
Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty is directly tied to the identity of the business owner. Whether the business involves plumbing or management consulting, the question is: Will existing customers automatically expect that a new owner will deliver the same degree of service and professionalism?
Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the percentage of business that might be lost under a change of ownership.
Market Value Approach
Market value approaches to business valuation attempt to establish the value of your business by comparing your company to similar ones that have recently sold. The idea is similar to using real estate comps, or comparables, to value a house. This method only works well if there is a sufficient number of similar businesses to compare.
Assigning a value to a sole proprietorship based on market value is particularly difficult. By definition, sole proprietorships are individually owned, so attempting to find public information on prior sales of similar businesses is not an easy task.
Which Approach Is Best?
Although the earning value approach is the most popular business valuation method, for most businesses, using a combination of business valuation methods will be the fairest way to identify and set a selling price. The first step is to hire a professional business valuator who will be able to advise you on the best method or methods to use to set your price so you can successfully sell your business.
Business owners should not do their own business valuation—they won't have the necessary distance to be objective.
To ensure that you set—and get—the best price when selling a business, have a valuation performed by a professional. A Chartered Business Valuator (CBV) can be found through the American Society of Appraisers (ASA) in the U.S.; in Canada, you can find them through the Canadian CBV Institute.
Valuation for Franchises
Franchise agreements generally define how a franchise can be sold, and these vary by franchise vendor, so check your franchise contract. Some contracts stipulate that the franchisors will buy back your franchise directly for a fixed price. Others assist with valuation and locating a buyer, as it is in their best interest to make sure that the business continues uninterrupted.
The Bottom Line
When people talk about business valuation, they are either referring to the process of determining the worth of a business, or they are referring to the value itself. There are many methods used to determine value, but three of them are most commonly used. The asset-based, earning value, and market value approaches can each help you arrive at a company's value.
In a perfect world, the three methods would all result in the same value. In practice, you are likely to calculate three different numbers. It's common practice to average the values to arrive at the fairest price.
Frequently Asked Questions
Below are the answers to three frequently asked questions about business valuation.
Is There a Rule of Thumb for Valuing a Business?
A general rule of thumb in business valuation is that you will want to use multiple methods. Using three to four methods will allow you to estimate fair value with more accuracy. If you only use one method, it may be correct or it may be high or low. When you look at the results of four methods that are relatively close to one another, you can take an average and feel more confident in the value.
What Are Common Mistakes When Valuing a Business?
The most common mistakes when valuing a business revolve around assumptions for inputs and comparables. For example, the earning value approaches require accurate assumptions for items such as earnings, cap rates, and discount rates. If any of those three are incorrect, the valuation will be off. An analyst could also overvalue assets or undervalue liabilities.
The market approach requires finding a group of companies that are similar to the company you are trying to value. If you do not select a group of closely related companies, the valuation will not be accurate.
When Valuing a Business, Is an Employee Salary Considered an Expense?
Yes, salaries and wages are included when valuing a business. Some salaries are directly tied to the skills required to successfully operate the business, and a buyer may need to retain key staff members to avoid losing valuable skills and competencies. Excluding or underreporting salary in order to boost earnings would result in a misleading valuation.