How to Do a Business Valuation
Determining your business's market value is an important task for a few different scenarios. Perhaps you're preparing for a merger, establishing a partner ownership or planning to sell your business, or you simply want to understand where your business stands in the industry landscape. In order to get those answers, you need to do a business valuation. There are three main methods to get an accurate assessment of your company.
[Read more: 5 Things to Know When Selling Your Small Business]
What is a business valuation?
A business valuation is the process of determining the economic value of a business, giving owners an objective estimate of the value of their company. Typically, a business valuation happens when an owner is looking to sell all or a part of their business, or merge with another company. Other reasons include if you need debt or equity to expand your business, if you need a more thorough tax analysis or if you plan to add shareholders. In this last case, the value of the shares would also need to be determined.
The valuation process tells the owner what the current worth of their business is by analyzing all aspects of the business, including the company’s management, capital structure, future earnings and the market value of its assets.
If you’re ready to value your business, here are the three approaches you can take.
[Read more: 3 Things to Consider When Selling a Business During a Pandemic]
If your business ... [is] worth about $5 million but similar companies have been sold in the $2-million range, you may lose money.
Three approaches to a business valuation
When your company is ready to go through a business valuation, there are three major approaches. Each one has its own benefits to consider, so it’s wise to evaluate which is best for you and your business.
Asset-based approaches
An asset-based approach totals up all of the investments in the company to determine the value of the business. When you choose an asset-based approach, all of your investments will be totaled up in one of two ways:
- A going concern asset-based approach, also known as book value, will review your company’s balance sheet, list the business’ total assets and subtract its total liabilities.
- A liquidation asset-based approach is used when determining the liquidation value or net cash value of your business if all your assets were sold and liabilities paid off. This is a common approach for business owners who are looking to sell their business or get out from under it.
Asset-based approaches work well for corporations, as all assets are owned by the company and are included in the sale of the business. For sole proprietorships, however, this approach can be a more difficult means of evaluation. If any assets belong to or are in the name of the sole proprietor, separating the value of business assets from their personal assets. For example, if a sole proprietor is ready to sell an IT company, prospective buyers of the business would have to take the time to sort through which assets belong to the business and which ones stay with the sole proprietor.
Earning value approaches
The earning value approach evaluates businesses based on their ability to produce wealth in the future. This approach is generally used for a company that is looking to buy or merge with another company. There are two types of earning value approaches:
- Capitalizing past earnings. This method reports the company’s usage of past earnings, normalizes them, then multiplies the expected normalized cash flows by a capitalization factor. This rate is what a reasonable purchaser would expect on their investment of the business.
- Discounted future earnings. This approach averages the trend of predicted future earnings for the company, then divides it by the same capitalization factor.
[Read more: How Do I Prepare To Sell My Business?]
Market value approaches
When assessing the market value of their business, owners establish what the business is worth based on similar businesses that have recently been sold. This sometimes leads to a business being under- or overvalued.
If your business and its assets are worth about $5 million but similar companies have been sold in the $2-million range, you may lose money on the sale. Earning value approaches are the most popular means of business valuations, but that doesn’t mean it’s the right choice for you. In fact, a combination of these three methods may be the best way to get a fair and accurate value for your company. The best way to get the fairest valuation is to hire an experienced business valuator to advise you on the best methods of how to evaluate your business.
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