Business valuation refers to the process of determining the economic value of a business. There are different business valuation methods that can be used to establish a business’s worth. Understanding how to value a company can be helpful for investors and business owners, but creditors and potential buyers may need to value a company as well.
What Is a Business Valuation?
Business valuation means determining what a business is worth. Again, there are different scenarios where the valuation of a business becomes important. For instance, business owners may be interested in knowing what their business is worth if:
• They hope to sell it to a new owner
• A merger with another business is in the works
• They’re creating an employee stock purchase plan (ESPP)
• They’re working on a succession plan that includes a buy-sell agreement
• They plan to apply for loans or lines of credit using business assets as security
• They need it for tax purposes
• The business is being sued
• It’s required for the division of assets in a divorce proceeding
•Valuing shares in an equity crowdfunding round
Venture capitalists and angel investors may also be interested in how a company is valued if they’re planning to invest before an IPO.
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How Are Companies Valued?
The business valuation process involves a detailed look at the company and its key financial characteristics. A professional business appraiser or an accountant that holds an Accredited in Business Value designation (ABV) typically completes a business valuation. These professionals have specially trained in calculating the valuation of a business. There are also business valuation software programs available that you can use to estimate your company’s value yourself.
Finding the valuation of a business can involve a number of factors, including:
• Ownership structure
• Company management
• Combined value of company assets
• Combined total of company liabilities
• Cash flow
• Revenues
That’s a general explanation of how business valuation works. To understand the valuation of a company at an individual level, it helps to know more about the different business valuation methods that can be used.
7 Business Valuation Methods
There’s more than one way to approach how to value a business. The method chosen reflects the reasons for determining a business valuation in the first place. For example, the methods used for company valuation ahead of an IPO may be very different from the valuation methods used for an existing company.
It can be helpful to use multiple business valuation methods when evaluating the same business. This makes it possible to see how the numbers compare, based on different metrics. Here are some of the most common ways the valuation of a company can be determined.
1. Market Capitalization
Market capitalization is a simplified way to find the valuation of a business, based on its stock share price. To find market capitalization, you’d multiply a company’s stock share price by the number of shares outstanding.
For example, if a company has 100 million shares outstanding priced at $10 each, its market capitalization value is $1 billion. Market cap is a fluid number, as share pricing can change day to day or even hour to hour.
Investors might use a company’s market capitalization when choosing stocks to invest in. For instance, if those interested in adding large-cap companies to your portfolio then they’d look for ones that have a market valuation of $10 billion or more. On the other hand, investors interested in small-cap companies would look for those with a valuation under $2 billion.
2. Asset-Based Valuation
The asset-based valuation method determines the value of a company based on its assets. Specifically, this involves looking at a business’s balance sheet and subtracting total liabilities from total assets. For example, if a company has $10 million worth of assets and $3 million worth of liabilities, its valuation would be $7 million.
This valuation method offers a fair market value of a company or business using assets as the key metric. It’s also referred to as a book value.
Businesses can use asset-based valuation to get an estimate of current value or what the business would be valued at after a liquidation event. Using the liquidation-based approach, the business’s value is measured by any net cash remaining after all assets are sold and liabilities are paid off.
3. Discounted Cash Flow Method
The discounted cash flow method for finding a company valuation estimates the value of an asset today using projected cash flows. Business owners use this business valuation method when they expect cash flow to fluctuate in the future.
A discounted cash flow method for finding the valuation of a business includes four elements:
• Time period for analyzing cash flows
• Cash flow projections
• A discount rate, which represents a projected rate of return from a hypothetical investment
• Estimated future growth
Discounted cash flow can help businesses get a sense of what their business is worth now, based on future cash flows. This can be helpful for businesses that are considering making investments in growth and want to gauge the estimated return on that investment.
4. Earnings Multiplier Business Valuation
With the earnings multiplier method, you’re finding the valuation of a business as measured by its current share price and earnings per share (EPS) ratio. Earnings per share represents the profit per common share compared to the company’s profits as a whole.
To calculate the earnings multiplier, you divide the market value per share by the earnings per share. So if a stock is worth $10 and earnings per share are $2, the earnings multiplier would be 5. That means that it would take five years of earnings at the current rate to get to the stock price. You can compare this data point to other companies in the same industry to get a sense of how its value compares to its peers.
The earnings multiplier method can be helpful for comparing the valuation of a company to its competitors. Essentially, what it tells you is how expensive a company’s stock is relative to the earnings per share it’s reporting.
Businesses can use the earnings multiplier approach to compare a company’s current earnings to projected future earnings. This method for how to value a business may be considered to be more accurate than methods that rely on revenues or assets alone.
5. Return on Investment (ROI) Valuation Method
Return on investment refers to the return an investor can expect from placing their capital into a specific investment vehicle. In terms of business valuation methods, this option bases value on what type of ROI an investor could receive from putting money into the business.
This type of valuation method might be useful for newer businesses that are trying to attract the attention of venture capitalist or angel investors. Using the ROI method, it’s possible to provide investors with a tangible number to use as the basis for estimating what type of return they could get on their money.
The formula for ROI-based valuation is simple:
ROI = (Current value investment – Cost of investment)/ Cost of investment
Similar to market capitalization this can be a very simple way to get an estimate of a company’s value.
6. Times-Revenue Method
The times-revenue method for business valuation helps find the value of a company on a range. This method applies a multiplier to the revenues generated over a set time period. The multiplier chosen depends on the industry the company or business belongs to and/or overall market conditions.
Compared to other valuation methods, the times-revenue method is not as precise since the multiplier used may be different each time the calculations are run. It also looks at revenues, rather than profits, which may paint a truer picture of a company’s value. This method of valuation can, however, be helpful for newer businesses that aren’t generating consistent revenues or profits yet.
7. IPO Valuation Methods
Some of the business valuation methods included so far are best for established businesses that are publicly traded on an exchange. In the case of a private company that’s preparing to launch an IPO, valuation requires additional strategies, since there’s no stock price to use.
When finding the valuation of a business for an IPO, the IPO underwriting team can use several strategies, including:
• Comparing the company to similar companies
• Looking at precedent transactions, such as mergers and acquisitions
• Running financial models, including a discounted cash flow analysis
If you’re interested in IPO investing, it’s helpful to understand how an IPO’s price is set. Pricing matters because if it’s too low, the company may not realize its goals for raising capital. If it’s too high, it may put off investors. Accurate valuation and pricing also comes into play during the IPO lock-up period, in which early stage investors are prohibited from selling their shares initially.
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The Takeaway
Knowing how to value a company matters if you own a business but it can be just as important for retail investors. If you’re a value investor, for instance, your strategy may revolve around finding the hidden gem companies, undervalued by the market as a whole.
Investing is, in many ways, all about value. Again, that’s what makes business valuation so critical to investors and business owners alike. In fact, as an investor, you are a business owner – remember to keep that in mind. And knowing how businesses are valued can help further your understanding of the markets at large.
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