A business valuation is how the story of a company, its history, brand, products, and markets, is translated into dollars and cents. Valuations are used by investors, owners, bankers, and creditors, as well as the IRS, and the process can have very different results depending on the objective. Accurately calculating value is both an art and a science.
Here’s an overview of the how, why, and who of business valuations.
- All business valuations are estimates of economic value.
- A business valuation is influenced by who does it and why.
- Pricing and valuation are not the same thing.
What Is Business Valuation?
Business valuation can be described as the process or result of determining the economic value of a company. All businesses have one thing in common: The goal is to generate profits for shareholders. Time frames, methods, and expectations differ, but the goal is the same.
Ultimately, the value of any business is the present value of expected future profits. The valuation process looks in depth at the operation, expenses, revenues, strategy, and risks of the business to arrive at assumptions for future earnings, time horizon, discount rates, and growth rates.
All business valuations are estimates. The objective of the valuation, and who does the analysis, heavily influences the end result. Investment bankers valuing a company to take it public want to justify the highest number possible, while accountants valuing a company for tax purposes want to arrive at the lowest number possible.
Valuation is different from pricing. Valuation is intrinsic; it’s based on the actual performance of the business. Pricing results from supply and demand; it incorporates market influences such as overall direction of prices, other investors, and new information such as rumors and news.
Why You Would Need To Do a Business Valuation
For an owner who may be looking for financing, considering a sale, or updating a financial plan, here are some common reasons for a business valuation.
Merger, Acquisition, and Financing Transactions
Valuations are fundamental to negotiations for the sale, purchase, or merger of a business. Valuations are used to benchmark buy-ins and buy-outs for partners and shareholders. Lenders and creditors often require valuations as a condition for financing. Valuations are also used to establish and update employee stock ownership plans (ESOPs).
Tax and Succession Planning
Valuations determine estate and gift tax liabilities and have an important role in retirement planning. Tax and succession valuations follow IRS guidelines.
Valuations are also often central to divorce proceedings, resolving partnership disputes, and settlements for legal damages.
The in-depth analysis of a business valuation can help owners better understand drivers of growth and profit.
Business Valuation Methods
The valuation method used depends on the condition of the business and the purpose of the valuation. The discounted cash-flow method is generally used for healthy companies generating a profit.
Discounted Cash Flow
The discounted cash flow method determines the present value of future profits, or earnings. The discount rate reflects the potential risk of the business not meeting profit expectations. A higher discount rate results in a lower value, which reflects a greater risk posed by the business. There are variations of the discounted cash flow method that use dividends, free cash flow, or other measures instead of earnings. The discounted cash flow method usually calculates the present value of five years of earnings adjusted for growth, and future earnings beyond five years (known as terminal value).
Net Asset, or Book, Value
The net asset value, also known as book value, is the fair market value of the business assets minus total liabilities on its balance sheet. Investors and lenders will consider net asset value for younger companies with limited financial histories. Net asset value is also useful as a lower limit for a valuation range, as it only measures a business’s tangible assets.
Liquidation value is the net asset value discounted for a distressed sale. Investors and lenders may consider liquidation value for younger or potentially distressed companies.
The market value method is a relative method. It compares a company with its peers and within its industry to arrive at a value by using multiples like price-to-earnings ratio (P/E). For example, one could value the Really Cool Fans Co. by applying an average P/E multiple for appliance stores to the company’s earnings like this:
Value = Price / Earnings Multiple 25 x earnings $120,000 = $3,000,000
The problem with using a relative method is that it incorporates any errors the market makes in valuing comparable companies as well as in the overall direction of prices.
What Business Valuation Means to Investors
Valuing a business is a complex process, and there aren’t any shortcuts. For the average investor, research reports can offer insights into a company’s value. The business valuation process is an in-depth analysis, yet at the same time, it’s only an estimate.
A basic understanding of the valuation methods, however, can help you clarify your investment philosophy and strategy.
A true value investor analyzes stocks independently of the market, and looks for gaps between value and price. They believe that over time, price will catch up with value. Price investors look for market trends in the demand for a stock using technical analysis, then try to get ahead of those trends.
Efficient-market investors believe the market accurately reflects value. Value and price investors use active management styles, by selecting specific stocks with a goal of outperforming the market. Efficient market investors use passive investment styles, such as index funds.
Frequently Asked Questions (FAQs)
Is the date of a business valuation important?
Yes, valuations for financial reporting and tax purposes have to be completed by a deadline. Valuations for mergers and acquisitions, financing, and other transactions have to meet the requirements of the parties involved.
What are the elements of a business valuation?
A business valuation can be thought of in terms of “why,” “how,” and “who.”
- Why is the objective of the valuation. Valuations done for different purposes will probably yield different results.
- How is the valuation method selected. Different methods will produce different results.
- Who is the person or firm performing the valuation. Their experience and philosophy will influence the results.
What are common mistakes when valuing a business?
For the average investor, the biggest mistake is confusing pricing with valuation. Pricing considers demand, and valuation doesn’t. Pricing and valuation are both used to make investment decisions, but they’re different.