Determining a company’s fair market value is a challenging job. You can figure out a company’s economic worth by applying a variety of measurements.
In this post, we’ll go over all you need to know about how to value your business, why you should, and how to avoid common pitfalls.
What Is Business Valuation?
Business valuation can be described as the process or result of determining the economic value of a company. All businesses have one thing in common: The goal is to generate profits for shareholders.
Time frames, methods, and expectations differ, but the goal is the same. Ultimately, the value of any business is the present value of expected future profits.
The valuation process looks in depth at the operation, expenses, revenues, strategy, and risks of the business to arrive at assumptions for future earnings, time horizon, discount rates, and growth rates.
Valuation vs Pricing
All business valuations are estimates. The objective of the valuation, and who does the analysis, heavily influence the end result.
Investment bankers valuing a company to take it public want to justify the highest number possible, while accountants valuing a company for tax purposes want to arrive at the lowest number possible.
Valuation is different from the pricing. Valuation is intrinsic; it’s based on the actual performance of the business.
Pricing results from supply and demand; it incorporates market influences such as the overall direction of prices, other investors, and new information such as rumors and news.
Check Out Why You Would Need To Do a Business Valuation
Business Valuation Methods
The valuation method used depends on the condition of the business and the purpose of the valuation. The discounted cash-flow method is generally used for healthy companies generating a profit.
1. Discounted Cash Flow
The discounted cash flow method determines the present value of future profits or earnings. The discount rate reflects the potential risk of the business not meeting profit expectations.
A higher discount rate results in a lower value, which reflects a greater risk posed by the business. There are variations of the discounted cash flow method that use dividends, free cash flow, or other measures instead of earnings.
The discounted cash flow method usually calculates the present value of five years of earnings adjusted for growth and future earnings beyond five years (known as terminal value).
2. Net Asset, or Book, Value
The net asset value, also known as book value, is the fair market value of the business assets minus total liabilities on its balance sheet.
Investors and lenders will consider net asset value for younger companies with limited financial histories. Net asset value is also useful as a lower limit for a valuation range, as it only measures a business’s tangible assets.
3. Liquidation Value
Liquidation value is the net asset value discounted for a distressed sale. Investors and lenders may consider liquidation value for younger or potentially distressed companies.
4. Market Value
The market value method is a relative method. It compares a company with its peers and within its industry to arrive at a value by using multiples like price-to-earnings ratio (P/E).
For example, one could value the Really Cool Fans Co. by applying an average P/E multiple for appliance stores to the company’s earnings like this:
Value = Price / Earnings Multiple 25 x earnings $120,000 = $3,000,000
The problem with using a relative method is that it incorporates any errors the market makes in valuing comparable companies as well as in the overall direction of prices.
What Business Valuation Means to Investors
Valuing a business is a complex process, and there aren’t any shortcuts. For the average investor, research reports can offer insights into a company’s value. The business valuation process is an in-depth analysis, yet at the same time, it’s only an estimate.
A basic understanding of the valuation methods, however, can help you clarify your investment philosophy and strategy. A true value investor analyzes stocks independently of the market and looks for gaps between value and price.
They believe that over time, the price will catch up with value. Price investors look for market trends in the demand for a stock using technical analysis, then try to get ahead of those trends.
Efficient-market investors believe the market accurately reflects value. Value and price investors use active management styles, by selecting specific stocks with the goal of outperforming the market.
Efficient market investors use passive investment styles, such as index funds.
What Makes A Business Valuable?
The amount a buyer is willing to pay for your business will all come down to two things, return on investment (ROI) and relative risk.
The lower the risk, the higher the price, and vice versa. With that being said, what really makes your business worth more when selling is mitigating the risk of the business failing in the future by having the following characteristics associated with your online store:
Predictable key drivers of new sales
Stable or growing traffic from diversified sources
Established suppliers with backup suppliers in place
A high percentage of repeat sales
A high percentage of repeat customers
Read Also: Common Mistakes to Avoid when Valuing a Business
Tips For Sellers
If you’re looking to get a business valuation so that you can sell your business, then you’ll likely want to know how to maximize the sale price.
Our top three tips to help you maximize the value of your business are:
1. Prepare for the Sale
Start preparing long before you put the business up for sale. Get your books in order and make sure there aren’t any accounting or reporting mistakes.
These can slow down the sale process, and make it difficult to maximize your value. The fewer things that look wrong when your business is analyzed, the easier it will be to get to closing.
2. Use a Business Broker
Using a broker not only will set your expectations at an acceptable level, but it could also make or break your entire sale. An experienced broker will be able to maximize the value of your sale and get you the largest sum possible for your business.
Brokers are often able to get much larger sale amounts than you’re able to get on your own. Choosing the best business broker for your situation also takes away many of the headaches that would otherwise fall on you.
Try outsourcing to a business broker so they can handle the administrative work, marketing your business for sale, communications with potential buyers, and negotiating both sales prices and final contract terms.
One consultation will provide you with answers to questions like:
What is my business worth?
Can the valuation price be increased?
How long will it take to sell my business?
What’s the next step?
Meanwhile, you can stay focused on operating your business, and continuing to maximize its value until it’s time to sell.
Tips For Buyers
Buying a business can often be even more complicated than selling, because you may not be familiar with the industry or business which you’re buying.
Many buyers start out with no clear understanding of the type of business they would like to own and wind up doing research on the fly.
Buyers should research industries that they are interested in to determine future potential while avoiding contracting markets.
The three tips to keep in mind as you look for the right business to purchase are:
1. Find an Industry with Potential
While you may pay more for a business in an industry with high multiples, it’s also more likely to hold its value.
This means that when you’re ready to sell the business in the future, you should still be able to get a higher sales price for it, especially if you choose an industry with high future growth potential.
2. Ask for Seller Financing
Seller financing is when the seller gives you a loan for part of the purchase price.
This can lower the financing amount you need to close the transaction, and you’ll typically get it at a cheaper cost than you would if you received a business acquisition loan for the whole purchase price.
Seller financing is common for small business transactions, but you should determine early on in the process whether it’s available from the seller.
A good place to start is with a nationwide business broker network, where listings are shared between brokers across the country.
Some brokers may charge an upfront fee for assisting buyers, and in return provide valuation and negotiation services, in addition, to helping to find the right business.
Pros of Using a Business Valuation Calculator
Using a business valuation calculator is a fast and simple way to get a ballpark value of a business without hiring an expert and with minimal effort; however, it’s not without its disadvantages.
Our business valuation calculator doesn’t factor in tangible and intangible assets which can both significantly impact a business’s actual value.
Some of the pros of using a business valuation calculator are:
Quick and simple: A business valuation calculator can be used as a quick and easy tool to ballpark a business’s value, which can be especially useful when comparing many like businesses to each other.
Valuation varies by industry: Most business valuation calculators include an average industry multiple in the calculation, which is useful as not all industries have the same risks and opportunities, which can significantly impact a business’s value.
Based on revenue and profits: By focusing on actual revenues and profits generated by a business, the valuation calculator is based on a business’s bottom line, which is how much money a business generates notwithstanding assets and liabilities.
Cons of Using a Business Valuation Calculator
Some of the cons of using a business valuation calculator are:
Doesn’t include assets: Our valuation calculator excludes tangible and intangible assets, which can make up a significant portion of the actual value of a business in asset-heavy industries. It should be combined with a valuation method that includes assets.
Not a market-based approach: For some businesses, bullish market trends may indicate a much stronger valuation. Conversely, for businesses operating in a contracting market, this approach may over-inflate the value of the business’s future revenues.
Excludes expert analysis: The biggest flaw in any math-based valuation method is the absence of expert analysis. No two businesses are exactly alike, and a math-based calculation ignores factors like intangible assets and year-over-year growth.
What works for one business won’t always work for another. By giving an overview of several popular business valuation methods, though, we hope you’re closer to understanding how much your business is worth.
The most important thing in a business acquisition, whether you’re a buyer or a seller, is to arrive at a fair price for the business. This involves several factors, and this article has successfully tried to point them all out.
If this article was helpful to you, do well to share it with others, as this might be helpful to them as well.
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