Determining worth: A deep dive into business valuation techniques

Company valuation is essential for various reasons such as attracting investors, distributing shares, determining share value for shareholders, seeking financing, and selling the business.

Business valuation is the process of determining the economic value of a business by analyzing all areas of the company. It is used for various purposes such as determining sale value, partner ownership, taxation, and divorce proceedings. Owners often seek professional evaluators for an objective estimate of the business's value.

Business valuation is a key topic in corporate finance discussions. It is typically undertaken when a company is considering selling a part or all of its operations, merging with another company, or acquiring a company. The purpose of business valuation is to determine the current value of a business using objective criteria and assessing all aspects of the business.

Factors considered in a business valuation may include the company's management, capital structure, future earnings potential, and market value of assets. Various methods, such as analysis of financial statements, discounting cash flow models, and comparing to similar companies, are commonly used for business valuation.

Methods of business valuation

There are various methodologies employed to assess the value of a company, such as scrutinizing its cash flow or applying discounting factors to annual revenue. Despite the range of valuation techniques available, three primary methods are commonly acknowledged. These include:

1.  Asset based approach

This method adds up all business assets and can be done on a liquidation or going concern basis. Let's delve deeper into this concept.

What is ‘Asset-based approach?’

This approach focuses on determining the fair market value (FMV) or net asset value (NAV) of the company by calculating total assets minus total liabilities. There is limited room for discretion in deciding which assets or liabilities to include in the valuation process. Additionally, other valuation methods include the market approach, which evaluates similar businesses in the market, and the earnings approach, which estimates future revenue. Further details on these methods will be explained in the article.

Detailed explanation of ‘Asset-based approach’

The asset-based approach to company valuation may undervalue the business as it often does not account for intangible assets such as business methods and internally developed products not listed on the balance sheet. Additionally, unique products or services that add value to the business can make determining a selling price challenging. Then why do we have it and when is this method used? The following would give you an answer to this.

Adjusted net asset method

The adjusted net asset method is used for businesses with losses, not operating, or only holding investments/real estate to estimate value. To determine fair market value, calculate the difference between total asset and liabilities.

Finding the fair market value of assets

The asset-based valuation method involves assessing the fair market value of the business's assets by revaluing them from historical cost to current value. This process includes determining the fair market value of each asset, such as through a real estate appraisal for land. The net asset value method is commonly used to restate the value of each asset. Once the fair market values of the assets are determined, they are subtracted from the total liabilities to calculate the final value of the company. 

2. Earnings approach

This valuation method focuses on future revenue potential, commonly capitalizing past earnings.

What is ‘Capitalization of earnings or capitalizing past earning?’

Capitalization of earnings is determined by calculating the NPV of expected future profits. This is done by dividing future earnings by the capitalization rate. It is an income-valuation approach that analyzes rate of return, cash flow, and expected business value to determine company worth.

Still not sure how this works? Let’s look at a detailed explanation to give you a better idea.

Detailed explanation of ‘Capitalization of earnings’

Capitalizing earnings is a conventional valuation method that helps investors assess the risks and returns of buying a company.

Finding a capitalization rate

Determining the capitalization rate for a company involves understanding different industries and conducting thorough research. Typically, small businesses aim for a 20-25% ROI when acquiring a business. Owner's salary should be separate from ROI calculations. For example, a business earning $200,000 yearly with a $50,000 owner's salary would have a $150,000 income for valuation. The capitalization rate is calculated by dividing operating income by purchase price. First, determine annual gross income, subtract operating expenses to find total operating income, then divide by purchase cost to get the capitalization rate.

Disadvantages of capitalization of earnings method

Determining a company's value through future earnings prediction can be inaccurate and lead to lower profits. Unexpected circumstances can compromise earnings and investment valuation. New businesses may lack sufficient information for accurate valuation. Buyers must consider ROI, risks, and growth factors in determining suitable investments. Failure to do so may result in missed opportunities or overpayment.

Capitalization of earnings example

A company consistently earns $500,000 annually with expenses of $100,000, resulting in $400,000 in profit. An investor values the business at $4 million by comparing its cash flows to a Treasury bond with a 10% return, also generating $400,000 annually. This method helps determine the value of the company based on similar investments.

3. Market value approach

The market value approach compares a company to similar ones that have been sold to determine its value and can be used for closely held companies. It requires a good number of comparable businesses for accuracy. This method can also be used to value intangible assets, securities, or business ownership interests by analyzing sales and making adjustments for differences in quality, quantity, or size.

Detailed explanation of ‘Market value approach’

Less than 1% of US companies are publicly traded, making it challenging to determine fair prices for privately held assets. The two main methods of valuation under the market approach are the Guideline Public Company Method and the Guideline Transaction Method.

Example of the market value approach

Property values are estimated by studying comparable properties and location. When determining the value of a company, investors look at recent sourcing transactions, industry trends, economic conditions, and operations. For example, analysts can assess the value of a cybersecurity company by comparing it to recently sold or newly public companies in the same industry with similar target customers, procedures, and revenues.

Areas of potential concern of the market approach

When analyzing a company using the market approach, focus on companies with comparable revenue/sales figures.

Which valuation approach is suitable for your company?

Selecting the appropriate valuation approach for your company is crucial, as there is no one-size-fits-all method. Various valuation methods exist, each with its own set of advantages and disadvantages influenced by industry norms, economic conditions, and interest rates.

Determining the right valuation method is essential for maximizing your return on investment up until the point of exit. Every business is unique and may require a tailored valuation approach. Companies with the most accurate valuations typically utilize a combination of valuation methods.

Many companies incorporate a comprehensive approach to valuation, drawing from various methods to determine the value of their business. This is essential because each company has a unique business model and strategy, making it necessary to tailor the valuation method accordingly. For example, an online business focused on customer engagement would require a different valuation approach compared to a traditional brick-and-mortar store.

Business owners who are willing to engage in discussions regarding their revenue streams, market comparison sale rates, and asset valuations stand a better chance of receiving a fair market price for their company. Additionally, investors will have greater confidence in the valuation process when presented with detailed data and insight into the company's operational procedures. This transparency and thorough analysis of the business operations build trust and confidence in the valuation process.