How To Determine the Value of a Business

Factors and Limitations of Valuation

Colleagues discussing charts and graphs on a laptop in an office
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Valuation in business refers to the process of placing a value on business assets and determining its overall worth. Valuation is important when it comes to making financial decisions about a company and negotiating with investors. Having an understanding of how to value a company is beneficial for both business owners and investors, especially those who may be looking to purchase or sell a business.  

The valuation process can be complex, especially for small business owners, as it uses multiple methods and can vary depending on the assets being valued and overall perceptions of value. Each process also has its limitations. Here we dive into the basics of valuation, the methods and factors that are used, and what you need to be aware of to accurately determine your business's value.

Key Takeaways

  • Valuation is a process that uses different types of methods to determine the overall worth of a business.
  • A business valuation is helpful when conducting major business transactions, including selling and acquiring a business, company mergers, and potential business expansion.
  • A valuation serves as a forecast of a business’s projected worth based on current data and may have limitations, including the potential for inaccurate data, economic impact, and the subjective interpretation of the value of intangible assets. 

Why Your Business Valuation Matters

The valuation of a business is important, as it gives insight to how much your business is worth, which is useful in various business dealings. Typically, investors and business owners are more interested in this number since it is used when making major financial decisions, such as selling and buying stocks, selling or purchasing a company, and company mergers. 

Valuation is also important if you are looking to expand your business, especially since you'll need more capital to grow. To raise this capital, you'll be asked to prove your business’s worth to potential investors. 

Factors That Impact Business Valuation

There are several factors that are considered when completing a business valuation. 

Financial Statements and Documents

To begin the valuation process, you will need to gather several documents and statements. A business appraiser will use the data from statements, such as your business's income statement, balance sheet, cash flow statement, and tax returns. These documents must be reported accurately to get a clear look at your company’s valuation. 

Reason for Valuation

Depending on the reason for the valuation, it may need to be certified. If the purpose of the valuation is simply for your internal purposes, this isn’t required. However, if the valuation is needed for potentially selling your business or for tax or legal purposes, then it will most likely require a lengthy report certified by a professional appraiser.

Book Value vs. Market Value

When analyzing the value of your business's assets, it’s important to understand that they may be valued at either book value or market value. Book value represents the actual amount that was spent on the asset, so it is equal to its price at the time it was purchased minus its depreciation. Though book value seeks to be accurate, it may make use of different methods for depreciating and doesn’t account for the current price in the market.

Market value considers the current value of an item. It determines the value of the asset as if it were available in the market today. 

Methods To Determine Valuation

Businesses can use different methods to figure out their valuation, including book value and market value. Some methods are based on the forecasted growth of the company, others consider the current market. Typically, more than one method is used to improve accuracy, and certified business valuations may use several types of methods. Some common methods include:

  • Discounted cash flow valuation
  • Relative valuation (market approach) 
  • Income approach

A discounted cash flow valuation estimates your business’s worth by calculating its future growth based on its expected cash flow. This method takes into account the current value assets based on how well you generate cash flow.

A relative valuation may be referred to as the market approach. It values assets based on the other values given to other similar assets, or comparable assets, in a market. This method considers the current market and essentially determines an asset’s worth based on competitor analysis.

The income approach looks at your business's income statement to evaluate its revenue and expenses. This method focuses on the value of profits and doesn’t account for intangible assets.

Using one or a combination of business valuation methods enables analysts to build the best model possible using as much information as they can legally access. This may prove to be a fluid process. As new information comes in, valuations should be updated to reflect the new information.

Limitations of Business Appraisals 

A valuation will offer significant insight into your company’s value, however, there are some limitations. It may not always be an accurate representation of your business's worth and may be interpreted differently by investors and potential buyers. A valuation essentially represents an estimate of how well your business is expected to perform, which can quickly change over time due to many factors. The current market and economy can play a role, as well as changes in the expected cash flow.

One important consideration is the potential inaccuracy of data provided from your company’s financial statements. If your business does not account for all assets and liabilities or leaves out pertinent data by mistake, the valuation will then be inaccurate.

If certain parts of the statements are interpreted differently, such as depreciation or using book value versus market value, this can also affect the outcome. Though some businesses may use both methods to improve accuracy, using only one may not equal the amount of a business’s assets when liquidated. 

Another limitation is whether goodwill is considered in the company’s worth. Goodwill refers to the additional amount an investor is willing to pay on top of its fair market value to acquire a company. It is the added value that isn’t represented in financial statements, as it includes intangible assets. Intangible assets are assets that are not physical items, such as trademarks, copyrights, client base, reputation, network connection, and other assets that are valuable, but are not actually valued with a dollar amount. The value of intangible assets may be interpreted differently and can even fluctuate depending on many factors, such as branding competition and market trends.

Due to changes in the market, you might consider conducting valuations on a regular basis to track your business. This is typically done on an annual basis but depends on the plans and goals you have for your company.

The Bottom Line

While business valuations can be helpful when completing major business transactions, such as acquisitions and mergers, they also have their limitations, as they are generally considered estimates of the business’s potential growth. When conducting a valuation, it is important to ensure your company's assets are properly valued and to consider different methods to create a more accurate representation of your business’s worth. 

Frequently Asked Questions (FAQs)

How much does a business valuation cost?

The cost of a business valuation can vary depending on the purpose of the valuation. Some can start at $3,000, while others may cost over $25,000. Business owners who want to gauge their valuation or keep track of their valuation can generally pay a lesser amount. 

How long does a business valuation take?

A business valuation generally takes several weeks to complete, as it is an extensive and detailed report. It can usually be completed in as little as three weeks but may take up to six weeks.

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Article Sources

  1. U.S. Small Business Administration. “Determining the Value of a Business,” Page 6. 

  2. University of Navarra IESE Business School. “Company Valuation Methods: The Most Common Errors in Valuation,” Page 7. 

  3. NYU Stern School of Business. “What Is Valuation?

  4. Allan Taylor & Co. “Business Valuation: 5 Questions You Must Ask Before You Start