What is business valuation?

Business valuation is a process and a set of procedures used to determine what a business is worth. Is it an art or a science?

Science is often seen as precise, and art as interpretation. In fact it is a bit of both.

You can try our free business valuation tool here to get an idea of what your business may be worth.

Getting your business valuation done right takes preparation and thought. And at the end there is no correct answer. At the end of the day the value of the business is the point where a willing buyer and willing seller meet and agree on a price. See also our blog on value is in the eye of the beholder.

However these three methods give great guidelines on how to value a business.

The circumstances of a business sale also affect the business value. There is a big difference between a business that is shown as part of a well-planned marketing effort to attract many interested buyers and a quick sale of business assets at an auction, known as a fire sale.

Three business valuation approaches

That said, there are three fundamental ways to measure what a business is worth:

  • Asset Approach
  • Market Approach
  • Income Approach

Asset approach

The asset approach views the business as a set of assets and liabilities that are used as building blocks to construct the picture of business value. The asset approach is based on the replacement cost which addresses this question:

What will it cost to create another business like this one that will produce the same economic outcome for its owners?

Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets and liabilities. The difference is the business value. However a business valued at or less than  its asset value is generally seen to be undervalued and is often viewed as a break up target as the sum of the parts may be greater than the sum of the whole.

Asset value is generally more relevant where the assets are the key determinant of the income stream of the business, as the value of the assets is linked to the income stream. i.e. equipment rental. It may also be used where the assets are intellectual property, where no income is generated but the potential for value is in the IP ownership.

However these values still comeback to what someone is prepared to pay, not necessarily what the accountant has recorded in the accounts.

Market approach

The market approach, as the name implies, relies on signs from the real market place to determine what a business is worth. This is easiest when we look at publicly listed vcompanies and apply their PE ratios to estimate a value to a similar business. However listed business PE are generally discounted to take account of increased liquidity, lower risk and size of the business. I.e if a listed equivalent is trading at 12, a 30-40% discount my apply to a private company in a similar space with less revenue.  i.e the multiple may then be 7-9.

What are  businesses similar to my business worth?

If you are looking to buy a business, you decide what type of business you are interested in and then look around to see what the “going rate” is for businesses of this type.

If you are planning to sell your business, you will check the market to see what similar businesses sell for.

In many cases this will come back to looking at industry equivalents that translate back to either a multiple on sales or earnings.

That mythical beast the fair market value is often quoted as the most appropriate valuation method but until you put it to the test it is always mythical!:

The business price that a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, and neither being under obligation to conclude the sale.

Income approach

So unless you are selling strong IP or rare assets then you are inevitably going to come to a revenue or income based approach to valuation.

You are always looking at the past performance of a business to determine how it will earn money for you in the future.

This can be done by either applying a multiple to current numbers or by looking at future earnings and applying a discount rate. The discount rate looks at the cost of capital but also the risk attached to the business. .

Since the business value must be established in the present, the expected income and risk must be translated to today. The income approach uses two ways to do this translation:

  • Capitalization or Multiples
  • Discounting

Business valuation by direct capitalization or multiples

In its simplest form, the capitalization method basically divides the business expected earnings by the so-called capitalization rate. The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two.

For example, if the capitalization rate is 33%, then the business is worth about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. Either way, the result is what the business value is today. The capitalisation rate is often also called multiples. The whole stock market works on multiples for the majority of its valuation, and this offers the easiest method of valuing a business. But how do you determine the multiple?  See our blog on determining your multiple in different sectors.

Valuation of a business by discounting its cash flows

The discounting method works a bit differently: first, you project the business income stream over some future period of time, usually measured in years. Next, you determine the discount rate which reflects the risk of getting this income on time.

Finally figure out what the business will be worth at the end of the forecast period. This is called the residual or terminal business value. Finally, the discounting calculation gives you the so-called present value of the business. Of course how you arrive at the terminal value of the business is a big determinant of the present value. There is some school of thought that ignores this, however this is a key factor for the buyer and should not be ignored.  Read our blog on how to make a million for more details on how this works.

Business valuation based on cash flow and risk

Business valuation and risk: discount and cap rates are related

Since both income valuation methods do the same thing, you would expect similar results. If fact, the capitalization and discount rates are related, the discount rate less the annual income growth rate should equal the cap rate.

Perhaps the biggest difference between capitalization and discounting is what income input you use. Capitalization uses a single income measure such as the average of the earnings over several years. The discounting is done on a set of income values, one for each year in the projection period.

If your business shows smooth, steady profits year to year, the capitalization method is a good choice. For a growing business with rapidly changing and less predictable profits, discounting gives the most accurate results.

Try our free business valuation tool to get an idea of what your business may be worth.

Why business valuation methods produce different results

Is it possible to use the income business valuation methods and arrive at different results? The biggest determinant is risk.  Look at our blog on risk to understand what drives risk.

Each buyer will likely have a different perception of the risk involved and may have different plans for the business, which will affect how they project the income stream and therefore value the company quite differently. Hence understanding what your business will do for the buyer is part of understanding the value equation.

As a follow-on to this targeting a specific group of buyers who can extract more value from your business should lead to a higher exit value.

That is what we call Strategic Exit Planning.

By taking this approach to selling your business we can help you unlock value and achieve the desired result, which is achieving your financial and personal goals.