3 Business Valuation Methods | equal view (2023)

If you're thinking about selling your business, buying a business, or looking for a way to better present your business to investors, it's important to know thereal value of your company. This is a fundamental part of running a business, and there are many methods toassessmentthat you can choose

Although theevaluation methodsseems like an easy wayFind the value of your company, There are many things to consider. By separating the different parts, you will be able to get the value of your business accurately.

But how do you get an accurate view of your business? And where do you start? There are many methods used today to find the value of your company. This article explains this and offers a detailed look at thethree main evaluation methods.

Introduction to business valuation methods

Before we dive into the different valuation methods, let's understand some basic reasons whyWhy do we need a business valuation?. From launching your business to new investors or distributingshare with your employees, an appraisal is needed to find the exact value of your business. Here are some more reasons:

• You may want to add shareholders, or ashareholderthey may be exiting and looking to liquidate their shares. In that case, you would have to determine the value of the company's stock through a company valuation.
• You may be looking for equity or debt financing. In that case, potential investors would see the value of the business before investing in your company.
• You may be thinking of selling your business. For this you need to know the real value of your business to get the most out of it.

The reasons can be many, but the value of your business is something that is important to know and depends on many factors, including the current state of the market, the financial statements of your business, and even what state it was incorporated in.

The most common are the three main valuation methods:asset based approach,gain focus, mimarket value approach.

What are the three common methods of business valuation?

There are numerous ways to value a business, from cash flow analysis to using discount factors in annual revenue. However, after summarizing these evaluation methods, three common methods are generally accepted. The three main types of valuation methods used are:

Asset-based approach

This method includes the sum of all assets placed in the trade. EITHERasset-based valuation methodsThey are generally done on a liquidation or continuity basis. Let's understand the concept a little better with the following explanation.

What is the "asset-based approach"?

This approach focuses onfair market value(FMV), or thenet worth(NAV) of the company. He calculated total assets minus total liabilities to find the cost of recreating the company. There is little room to decide which of the company's assets or liabilities should be included in the company's valuation and how exactly to measure the value of each.

Other than that, there are two other valuation methods that are used. EITHERmarket focus, which looks at the value of similar businesses on the market, and the profit approach, which estimates the total amount of money the business can make in the future. These two would be explained later in the article.

Detailed explanation of the "asset-based approach"

Or real value notasset based approachto calculate the company's valuation can be much higher than the sum of all the registered assets of the company. Take, for example, the balance sheet of the company. The balance sheet does not always contain all significant assets, such as the company's methods of conducting business and internally developed products.

This is because only records that the owner has paid for appear on the company's balance sheet. So if there are other business assets, they are not recorded on the balance sheet. Other than that, some companies may have special products or services that make them unique. Pricing your business for sale can be difficult.

In short, although this method is common, it cannot be used alone, since it would not represent the exact value of the company.

So why do we have it and when is this method used? The following would give you an answer to this.

Adjusted net assets method

Oadjusted equity methodIt can be used when a business is making a loss, is not operating, or the business only owns investments or real estate. This is one of the valuation methods used to obtain the estimated value of the business.

To get the fair market value, we would need to find the difference between the fair market value of the company's total assets and total liabilities. Let's understand how this is done.

Finding the fair market value of assets

The asset-based valuation method begins by preparing a financial picture of the business from the information we have on the balance sheet. The present value of the asset would be different compared to theacquisition cost. Although the balance sheet will have all assets and liabilities listed at historical cost, the correct use of this approach relies entirely on restating these costs and obtaining present value.

Basically, the assets are reviewed, determining the fair market value of each of them. Let's give an example to understand this better. A homeowner can work with a real estate appraiser to obtain the fair market value of a piece of land. And with that, the homeowner could discover that the land he bought 10 years ago for $1 million is worth $3 million today.

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With this discovery, the land would then be revalued by US$3 million, applying the net asset value method, which is one of the common valuation methods. The same is done for each company asset.

On the other hand, liabilities are often already in line with fair market value. Therefore, in most cases, no calculations are needed to determine this. Finally, thefair market value of assetsare deducted from the total value of the liability, resulting in the final value of the company.

profit focus

This is another common valuation method and is based on the idea that the real value of a company lies in its ability to generate income in the future. There are manyevaluation methodsunder the earned value approach, but the most common is to capitalize past earnings.

What is 'Capitation of Earnings or Capitalization of Past Earnings'?

The capitalization of profits is determined byNPV calculation(Net present value) of expected future cash flows or earnings. The estimate here is found by taking the company's future earnings and dividing it by a capitalization rate.

In short, this is arevenue valuation approachwhich allows us to know the value of a company by analyzing the annual rate of return, the current cash flow and the expected value of the business.

Still not sure how this works? Let's see a detailed explanation to give you a better idea.

Detailed Explanation of 'Earnings Capitalization'

This profit capitalization approach, being one of theconventional assessment methods, helps investors discover the potential risks and rewards of acquiring a company.

Finding a cap rate

Determining a company's capitalization rate includes knowledge of different types of industries and businesses, as well as a significant amount of research. Typically, the rates used for small businesses are 20-25%, which is the ROI (return on investment) that every buyer is looking for when choosing which business to purchase.

Since ROI typically does not include the owner's salary, this figure must be separated from ROI calculations. Take, for example, a small business that makes about $200,000 a year and pays the owner FMV (Fair Market Value) of $50,000. The remaining $150,000 is used as income for assessment purposes.

Once all the variables are known, thecapitalization rate calculationIt is obtained with a simple formula. The formula is the operating profit divided by the purchase price. At first, what must be determined is the gross annual return on investment.

After that, operating expenses must be subtracted to get the total operating income. This value is then divided by the acquisition cost of the investment/property to find the capitalization rate.

Disadvantages of the earnings capitalization method

There is no perfect method for determining a company's value, so evaluating a company's future earnings has some drawbacks. Initially, the method used topredict future earningsmay provide an inaccurate value, ultimately resulting in lower-than-expected profit generation.

In addition, exceptional circumstances may occur that eventually compromise the results and affect the valuation of the investment. Additionally, a company that has just entered the market may not have adequate information to discover an accurate valuation of the company.

The buyer must know everything about the desired ROI and acceptable risks, since the capitalization rate must be reflected in the risk tolerance, the characteristics of the buyer's market and the expected growth factor of the business. For example, if a buyer does not know the target rate, he may miss out on a more suitable investment or overpay for an investment.

Example of Capitalization of Profits

Let's take the example of a company that, for the last ten years, has earned and had cash flows of about $500,000 per year. Based on the company's earnings forecasts, the same cash flow would continue for the foreseeable future. Expenses for the business each year are only $100,000. Therefore, the company earns revenue of $400,000 per year.

To calculate the value of the business, an investor looks for other risky investments that have the same type of cash flow. The investor now recognizes a $4 million Treasury bill that yields about 10% per year, or $400,000. From this, the investor can determine that the business is worth around $4,000,000. This is because it is a similar investment in terms of risks and rewards. This would be a method to determine investments similar to the value of a company.

Market value approach

Omarket value approachIt is another standard valuation method and is done by comparing the company with other similar companies that have been sold in the market. It can be used to calculate property value or as part of the valuation method of a closely held company. Unlike the other methods, this can only work if there are a good number of similar business types for the company being compared.

Additionally, this approach can be used to discover the value of an intangible asset, value orcommercial propertyinterest. The market approach analyzes the sales of each similar asset and adjustments made for differences in quality, quantity or size, regardless of the asset being valued.

Detailed explanation of the "market value approach"

While it's easy to value publicly traded companies based on their share price at any given time, less than 1% of all American companies are publicly traded. And for this reason, it becomes a challenge for those who seek to obtain a fair price for a closed asset. Two of the significant valuation methods under the market approach are:

• OOpen Company Method Guidelinewhich uses the prices of similar publicly traded companies; Is
• The Guideline Transaction Method that uses the prices of recently sold related companies.

Example of the market value approach

The value of a property can usually be estimated by studying thecomparable in real estate, like the current properties sold, and that had similar characteristics and size. Other things are the location, which also helps us to know the value of that property. When it comes to companies, investors often look at things like recent sourcing transactions (sales, mergers), industry, economic condition, and close of business.

Let's take as an example a young cybersecurity company, where we would like to know the value of this company. The analyst would first look at recently sold cybersecurity companies or those that have just gone public. He would look for certain clues, such as whether private companies and new IPOs are targeting the same type of client, relying on similar procedures to keep their clients safe, and have similar revenues.

Areas of Potential Concern for Market Focus

When analysts and investors conduct analysis to determine the value of a company through the market approach, they must pay close attention to revenue or sales figures. It is important to choose companies with similar revenues or sales size.

Which approach is right for you?

There is no one-size-fits-all type of business valuation, as there are manydifferent valuation methods for various companies. Of all the evaluation methods, there is no perfect method. Each has its own advantages and disadvantages depending on a variety of factors, from industry valuation norms to the current economic market and interest rates.

Selecting the right one for your business would be a significant part of your return on investment by the time you leave. Every business is different and each would have a different way of doing the valuation. Companies with the best valuation use more than one valuation method.

Many companies use a much broader valuation approach, drawn from each of the valuation methods mentioned above. The main reason behind this is that each company has a different idea and business model and therefore not all companies can use the same method. For example, an online business built around customers would have a different way of valuing the business compared to a physical store.

Business owners who are open to discussing existing differences in their revenue streams, comparative selling rates of other companies in the market, and their own company's asset valuations would have a much better chance of getting a fair market price for your company. In addition, investors could understand that companies have complete data and understand the regular processes that take place in the business, which would give them more confidence in valuation.

Out of all of that, there is one mistake that many business owners make; they do not seek guidance from a professional. And the reason why he needs expert advice is that since he is attached to his business, he would not be able to see things objectively. With the help of an expert, you will be able to discover any hidden value in your business.

independent evaluation

Now that you know what the various evaluation methods are, let's understand what an independent evaluation is.

When a business is about to be sold, for purposes of commercial financing, legal separation of owners, exit or incorporation of business partners, part or all of theownership of the business is transferred. That is when a business valuation is used. The people who typically receive a business valuation include buyers and owners, courts, legal professionals, investors, business creditors, and tax authorities.

A business owner must do their own business valuation, but by experts. If a business owner does this alone, he may make a miscalculation and overestimate or underestimate the value of the business. In addition, the company may not have a safe haven if theIRSdecides to investigate further.

Therefore, to ensure that you get the exact price for your business to sell or to obtain investment from outside investors, it is important to have the business evaluated by a professional. The person valuing her business would use many different valuation methods to calculate the fair price of the business.

You must be thinking, what does this have to do with valuation methods or company valuation? Well, the assumptions you make whileestimate the value of your businessit would make a big difference in the results of your business assessment. That's why you need to get an accurate valuation of your business from an independent appraiser.

Conclusion

At the end of the day, it doesn't matter if you plan to sell your business or not, it's always a good idea to have aComprehensive evaluation of your business carried out. Having a thorough understanding of the economics of your business will give you a clearer picture of your business, especially if you areLooking for investors to finance your business.

But the above methods are not the only ones. There isother methodsand many companieschoose more than one method to value your business.