Businesses are bought, sold, and liquidated all the time. Furthermore, business owners frequently need to approach investors or business partners for cash injections or other dealings. But all of these activities can only happen if the actual value of the business at hand is known.
This can be difficult to tell from the bottom line of a business's balance sheet. However, there are multiple methods of business valuation that business owners, shareholders, investors, and valuation agencies can use to estimate the value of a business based on assets, market environment, and other factors.
This guide will break down the eight major business valuation methods to use, as well as explain when each valuation method is appropriate for the target company. In addition, for a company to hold any value at all, this earlier post explains how to prevent your business from failure.
What is Business Valuation?Business valuation is a process where you (or someone you hire) determines or "values" the total economic worth of a company or business. In other words, business valuation involves tallying up the total value of a business's assets, finances, current wealth, and more, to come up with a single "total" amount of value.
Why is Business Valuation Important?
There are many reasons why a company or entrepreneur may need to perform a business valuation on either their own company or a competitor's business.
The total value of a business affects:
- How much that business might sell for in the future – for example, an auditor or business valuation agency may value a business in order to determine how much a business owner should charge someone to purchase it from them
- Likely future value for the business – in many cases, businesses that are valued highly currently may be valued even more highly in the future depending on many complex factors
- The negotiation strength a business has when merging with another business or when negotiating with any other company for other reasons
- The value of the company for an IPO, or initial public offering (basically when a company goes on to the stock market), or when negotiating with shareholders
- The investors or business partners a business can seek, particularly for startups
In many cases, business valuation is performed so that business owners can sell a business for what it's fully worth, making as much of a profit as possible.
However, business valuation is only effective if it's accurate. This is why there are multiple business valuation methods that companies or agencies can use to determine the value of a company. Different valuation methods may be more useful depending on the circumstances of the company, the actual assets it has, how much it is currently worth, and more.
Business Valuation Methods
There are many more than eight ways to perform a business valuation, but the below methods are the most popular and commonly used both by agencies and business owners.
#1: Market Value Valuation
A market value valuation method is one of the most common ways to measure the worth of a company. But it's also among the most subjective.
In a nutshell, this valuation method involves comparing one target business against similar businesses in the same market area or niche.
Essentially, it's valuing a business against its direct competitors by looking at those competitors and how much they're worth.
Naturally, this means that the market value valuation method is only appropriate for businesses that have a lot of competition in the first place. Smaller or more niche industries may not be appropriate for this valuation method.
Furthermore, the market value valuation method is relatively imprecise. Agencies or business owners may not be able to get accurate information about the real value of their competitors, for example.
Still, this method is often used with startups in growing industries with a lot of high-value competitors (see also best business plan advice for your start-up to succeed).
#2: Asset-Based Valuation
The asset-based valuation method is a little more fact-focused.
As the name suggests, this involves valuing a business based on its total net asset value.
To start, the agency or business owner tallies up the total net worth of all combined assets, such as property, equipment, products, and so on. To complete the valuation, the business owner or agency must also subtract the value of a business's total liabilities, which can include payroll, business tax (see also FUTA), maintenance costs, and debt.
This valuation method is most useful for businesses that keep excellent records of their total assets, products, and other income sources. It may be less useful for businesses that are primarily focused on services instead of products, however.
#3: Return-on-Investment-Based Valuation
A return on investment or ROI-based valuation method calculates the value of the company based on profit. The return on investment is another term for profit overall – it just means how much a company can expect to make in profit after any necessary expenditures or investments.
The ROI-based valuation method involves focusing on the profits that a business will make consistently in the future.
This makes it a popular valuation method for businesses that need to pitch themselves to investors.
For example, startups may (wisely) not focus on their current profits but instead present projected ROI values for investors. The hope is that this valuation method demonstrates the potential and eventual value of a business even if it isn't bringing in high profits at first.
ROI-based valuation methods take a lot of and data to be successful. Furthermore, there's always the chance that even the best projections could end up being incorrect in the long run, resulting in unhappy investors.
#4: Discounted Cash Flow Valuation
Also called the DCF method or income approach method, this involves valuing a company based on projected cash flow.
The cash flow is then adjusted or discounted to the real-world present value.
This is a useful valuation method for companies whose profits are not necessarily consistent. For instance, freelancers or small businesses focusing on curating a client base can use this to value their company's overall cash flow while also accounting for the inherent instability of their industry. On another note, if you need a cash injection, you must know the actual value of your business - this is where capital lease vs operating lease comes to play.
However, this valuation method does require extra attention to detail and very careful data analysis to be accurate. It may be wise to hire an accountant to make sure all your data is correct before relying on this analysis for big decisions.
#5: Capitalization of Earnings Valuation
The capitalization of earnings method means combining the cash flow, expected value, and annual return on investment for a business.
All three factors together can theoretically help to value a business's total future profitability.
Thus, it's another projected and somewhat subjective valuation method mostly used by startups looking for investors or for companies looking for favorable IPO conditions when they enter the stock market. This method is best used for stable businesses whose income can be counted on to remain consistent over several years.
#6: Times Revenue Valuation
This valuation method also looks at a company's potential value by examining its potential earnings in the future.
This is primarily used for small businesses.
In a nutshell, it involves looking at streams of revenues generated over profitable periods of time for a business. That revenue is then applied to a multiplier that is calculated based on market factors, surrounding industry conditions, and competition. The final number theoretically results in the total projected value for a company (provided their profits stay the same).
#7: Book Value Valuation
The book value valuation method requires businesses to calculate their value in a "snapshot" format by looking at the numbers on a balance sheet.
A company's balance sheet will hold the value of equity (essentially the value of combined assets minus liabilities like debt or maintenance costs), which serves as a stand-in for the business's current worth.
This could be a good valuation method for businesses that have low profits but extremely valuable assets, such as older companies finally running out of steam but that might have significant property and equipment that they've collected over time.
#8: Liquidation Valuation
The liquidation valuation method is primarily used for companies that are being liquidated (i.e. they've gone bankrupt and their assets are now being distributed to pay off remaining debts and satisfy shareholders).
As the name suggests, it involves calculating the value of a company by tallying up the value of all company assets if they were liquidated and all company debts were paid off immediately.
As you can see, there are many different valuation methods that agencies, auditors, and business owners can use to calculate the total or projected worth of a company at any point in its lifespan. It's a good idea to consider each valuation method carefully, as some methods are better for certain businesses at certain points than others.
Furthermore, don't discount the value that an excellent business loan can provide to your company if you're trying to grow your value over time.