What is a Business Valuation?
Business Valuation can be defined as the result of a process and procedures, used in estimating what a business is worth or its economic value. It is noted that a business value is not always straightforward. And for you to get the right business valuation, you are going to conduct a considerable amount of research on the company and its current market.
Why Do You Need a Business Valuation?
The need for a business valuation will depend on some factors, such as the size of the business or the industry. This process can be somewhat very difficult, and complex. And it requires several calculations to determine. And the question is, why do we need a business valuation in the first place? The answers are listed below,
When we need to sell our business.
If you want to add shareholders.
When you are looking for business investors or financial advisors.
When you want to merge or acquire a business.
While you are establishing partnership and ownership.
FIVE BUSINESS VALUATION METHODS
There are five main methods or ways by which you can value your business, assets, income approach, market approach, return on investment approach, and discounted cash flow approach.
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The method of asset approach involves, totaling up all investments in your business. This is a business valuation that is made up of assets and liabilities.
What this involves is that, the content of your balance sheet creates the foundation for the value of your business.
– Going –concern asset-approach
This involves taking the business asset net balance sheet sum of your assets and then subtracting the sum of its liabilities.
– Liquidation-asset–based approach
This involves evaluating the net amount that you will receive if all assets were sold and liabilities paid off. Asset–based valuation methods do work well in corporations. This is because the assets are owned by the company itself, and are included in the sales. This approach or method is not good for sole proprietors, as it is very difficult to separate personal and business assets. We can use this as an example. A sole proprietor intends to sell his company, and his prospective buyer has to sort through assets, to determine which asset belongs to the owner and which belongs to his business.
Both of these methods will require a strong understanding of the business’s current standing and balance sheet. The business valuation method asks, ‘what it will cost to build an identical business’.
Whenever you are valuing a business with a market approach method, you have to look up an external marketplace. What it means is that you have to know what other businesses that are competitive or similar to mine are worth.
This is somewhat like buying a house, and you have to look for comps and then evaluate the worth from there. This method of evaluation is not always an option when you are creating a category. Because this can only work if there is enough to compare it against.
You should realize that the going rate is called the fair market value. which is a value that is exchanged between the buyer and the seller. However, thi is agreeable and mutually beneficial to both parties.
Let’s take for example, if your business asset is worth $ 5 million and if a similar company to your own company is being sold for $ 4.5 million range, you could probably end up losing money on the sale. This market approach might be the popular one. but evaluating it to be the right approach to your business is the right key to doing the right business valuation.
This type of approach is also known as the earning value approach. And this relies heavily on the business being profitable in the future. The question is what is the most important when valuing your business? Return on Investment. This type of valuation puts ROI in the front and center. Thereby basing off on what somebody will expect to make on their investment.
– Capitalizing Past Earnings
You have to protect the company’s potential profit based on its past earnings. However, try to adjust them for unusual or one-off expenses or revenue. And then multiply them by a capitalization factor.
– Discounted Future Earnings
Here you will determine the value by averaging the trend of predicted future earnings. And then dividing them by the capitalization factor.
You ought to understand that,l the capitalization factor has to largely depend on the earning history of the business. This can range from 12% for an established business, and 50% for an unproven business in a volatile market.
Also note that if your business shows a steady profit growth over a year, the capitalization method based on past earnings will be the right way to go. If you are the type that is always changing start-ups, the best bet for your business will be discounting your future earnings.
If you want to calculate your business value with the help of capitalization past earning method under this income method you have to use the following formula,
Business value –Annual future earnings/Required rate of return.
Let’s take for example a real estate company with the BWA forecasted earning $19 million and the required rate of return is 12%, your business value will be $19 million / 12% = $158.33 million.
RETURN INVESTMENT APPROACH
This method allows you to value the business based on the profitability and the ROI that an investor can potentially receive when they buy into the business. Let’s use this as an example, let’s say you pitch the business to an investor and demand $250,000 in exchange for 25% of your business. You have to divide the amount by the percentage you offered $250,000/0.25 = 1 million.
DISCOUNTED CASH FLOW
This type of method values business on projected cash flow adjusted to its present value. This is useful especially when profit is not projected to remain constant in the future. The formula for calculating this is as follows,
DCF- Terminal Cashflow /(1+Cost of Capital)