Whether you're starting a business, growing your business, or trying to sell your business, you should have a rough estimate of your company's valuation at all times. Knowing your business's value makes it easier to apply for loans, pitch to investors, and more.
It's always recommended to consult a professional when it comes to business valuation — but that doesn't mean you shouldn't learn how to do it yourself. In this article, we'll discuss business valuation, why it's important, and the different approaches you can take to determine your business's value.
What Is a Business Valuation?
A business valuation is the process of determining your company's worth. The valuation represents your business's current fair value. You can calculate it by using a formula or taking stock of your assets, earnings, industry, and debts or losses.
Your company's valuation changes from one period to the next. For instance, it increases if you acquire more assets and make profits. On the other hand, if you experience a loss, the valuation declines. The final number you get from doing a business valuation also varies depending on the method you use. You'll find that the method of valuation also impacts the steps, costs, and time it takes to do the valuation.
Uses of Business Valuation
An accurate business valuation is needed when a business owner is looking to sell all or part of their business. Companies in merger negotiations also need to show each other their business valuations. A valuation is also useful for a business owner when:
- You're applying for loans
- You're looking for investors or you plan to welcome a partner
- You need to determine a tax plan
- You're in the middle of legal disputes, such as a divorce proceeding
- You want to know the financial health of your company
Methods of Valuation
Here are methods you can choose from to determine your business's worth.
Market Value Approach
The market value approach calculates a company's worth by looking at other similar companies that sold recently. Then, the fair market value is established based on selling prices. This valuation method works if your business operates in a crowded industry and you can find comparable businesses. Otherwise, the market value approach could result in your business being undervalued or overvalued.
The income-based approach assesses a business based on its profitability and earning potential. If you want to take the income approach, these are the two commonly used valuation methods:
- Discounted cash flow method (DCF): This valuation method estimates the value of the business based on its expected future cash flows. It is typically used for companies believed to have high-growth potential but are not profitable yet. This method calculates the business's value today based on projections of how much income it will generate in the future.
- Capitalization of earnings method: This method calculates a company's future earnings based on its cash flow, the annual return on investment (ROI), and expected value. The capitalization method is typically used to value established businesses. This is because the future earnings are calculated based on current income, assuming that it will not change in the future.
Asset-based approaches determine the value of a company based on all of its investments or assets. If you want to use an asset-based approach, you may use one of two methods:
- Going concern approach: This method calculates the book value of a business. To calculate your business's worth, you simply add up the value of all of your assets and deduct liabilities. If you're selling your business, this approach assumes the company stays up and running and that the new owner won't be selling off major assets.
- Liquidation value: This method calculates the net cash value of your business if all of your assets are sold and you pay off all debts. It's a common approach used by business owners who are looking to liquidate failing businesses.
Choosing a Valuation Method
Whatever your purpose for doing a business valuation may be, remember that the more information you have, the more accurate your calculations will be. Before you choose a business valuation method, make sure you have the following documents:
- Financial statements for at least the last three years
- Copies of all the business's tax returns
- Licenses, deeds, patents, and other proprietary documents
- An up-to-date balance sheet for the business
If you're selling your business, your goal in choosing a valuation method is to maximize your profits. Compare and contrast the different ways before you decide. For instance, asset-based valuations don't take into account a company's good business standing, its relationship with customers, or any kind of established branding. Instead, the business is valued merely on the market prices of its equipment, real estate, inventory, and other assets.
On the other hand, the market value approach can also result in your business being undervalued if a similar business recently sold at a low price. Not to mention, it may be challenging to find comparable companies to base your valuations from. Income-based approaches are the most popular ways of valuing a company because they take the business's potential into account. Still, you don't have to go with what's popular if it doesn't work for you.
If you're unsure of which method to use, the best way to get a fair valuation is to consult a professional business valuator. They can advise you on the best strategy for assessing your business. Find a business appraiser who has experience and knowledge of your industry; they may be able to give you a more accurate number than the one you'd calculate on your own.
Calculating Your Valuation
Small business valuations are typically expressed in Seller's Discretionary Earnings (SDE). The SDE is a metric that calculates the historical cash flow of a business. It is usually used in small businesses to account for the owner's draw and benefits.
To determine your SDE, follow these steps:
- Take the net profit amount from your business tax or year-end income statement
- Add back whatever amount you paid yourself
- Add non-cash expenses, like depreciation and amortization, and any non-recurring expenses, like the purchase of equipment or repair costs after an accident
- Subtract any liabilities, such as debts, unpaid bills, etc.
- The final number is your SDE
The SDE represents the monetary value of your business based on income. To get the market value of your business, multiply your SDE by your industry multiple or multiplier. Doing this will give you your business value according to industry standards.
Every industry has its own SDE multiple. A business appraiser will determine your industry multipliers based on:
- The size of your business
- Market trends and volatility
- Your business location
- Your business assets
The higher your SDE multiple, as you might expect, the more your business is worth. However, if you're selling your business, the appraiser will also consider how much risk is involved in transferring ownership. For instance, your clients may not want to work with the new owner if your business is tied to your expertise or personal skills. Thus, the risk will be higher.
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Whichever method you choose to determine your business valuation, understand that the foundation of a fair business valuation is accurate accounting and reasonable estimates. Overvaluing your business can turn away potential buyers. Undervaluing it means that you're losing out on profits.
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Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure that you're meeting accounting standards and making the best decisions for your business.