Business valuations are one of those tasks that many business owners plan on doing, but don’t always get to. There are many reasons why this may be the case. They can be fairly daunting, and many business owners don’t want to pay someone else to conduct a valuation for them. Plus, business valuations are mistakenly often perceived as not important enough to devote a significant amount of time or money to. Do you fall into any of those viewpoints? If so, we at Saddock Advisory want to advise you to consider the many business valuation methods more carefully.
In this article, we will discuss:
- what exactly business valuations are
- why they are important
- why you should hire professional help with them
- what the different methods of valuation entail
What Are Business Valuation Methods?
It is a process that combines professional expertise and analysis of various aspects. This analysis leads to a reasonable resolution of what a business is worth, or its true value. However, it is not just plugging in numbers and spitting out a value.
The process actually involves many more factors. Hence, we highly recommend hiring a professional to lead you through the business valuation process.
Involving a professional gives you the peace of mind that someone with experience is calculating the value of your business. In addition, it assures you that the calculation is objective. Even if you have experience in business valuation, doing this process on your own business can be a slippery slope.
What Does Business Valuation Involve?
Many factors go into business valuation. The three most common factors are cost, market and income.
These are all important categories to look at when valuing a business. However, it is also essential to consider other internal and non-financial factors when conducting a business valuation.
When we undergo a valuation at Saddock, we first assess all relevant financial information, such as:
- tax returns
- recent financial statements
- forecasts
- projections
- business plans
We also involve non-financial information such as:
- business risks
- geographic market
- management team
- competition
- background and history of the company
- strategy and future plans
Why Get a Business Valuation for Your Company?
The most common reason for conducting a business valuation is because the owner is selling their business. This is a very good (and necessary) reason to undergo a business valuation. But there are so many more reasons as well.
In fact, we recommend conducting valuations annually because they are so useful. Another common reason is if your company is undergoing expansion. A business valuation should provide your bank with all of the information they need to approve your loan. This way, you can secure financing for expansion and construction.
If a partner is leaving your business, it is often necessary to conduct a business valuation to accurately split up shares in the company.
In addition, business valuations are also necessary when going through a merger with another company.
And finally, there are instances in which you likely will wish you had a current business valuation if you don’t already. Unforeseen circumstances such as natural disasters may create a situation where you need to know your company’s value before and after the event. Thus, having a current business valuation handy will save you a lot of headaches.
The Most Common Business Valuations Methods
There are three main approaches to business valuation. And within them, there are many different methods for assessing business valuation.
Asset-based method
The goal of asset-based business valuation is to look at all of the investments in the company.
Thus, to get an idea of a company’s value, these assets actually include tangible and intangible business assets like:
- equipment
- inventory
- trademarks
- customer relationships, etc.
Within this approach, there are two primary methods: the going concern asset-based approach and the liquidation asset-based approach.
The going concern approach subtracts the business’ total liabilities from its net assets to come up with its value (or the book value). As a result, the going concern approach examines the business’ balance sheet.
The liquidation approach determines a business’ liquidation value. Thus, this is the net cash it would receive if it sold and paid off all its assets and liabilities.
Income-based (or earning value) method
The idea behind using an earning value approach is that a business’ greatest determinant of value is its ability to produce wealth.
Economically speaking, this is all about expectation. A business’ value is equal to the value of its income that an assessor can reasonably expect it to generate in the future. In doing so, an earnings approach will typically account for potential investment risks. It will also discount returns on investment at a rate of return that takes into account such risks.
Several common valuation methods fall under the earning, or income-based approach.
The capitalizing past earning approach takes into account a business’ previous earnings. Next, it normalizes them to eliminate outlier revenues or expenses. It then uses these numbers to calculate future earnings.
Discounted future earnings is another approach. Instead of averaging past income, this approach takes predicted future earnings and averages them to calculate the business’ value.
Discounted cash flow method
Perhaps the most common income-based approach to business valuation is the discounted cash flow method (or the dcf method). It determines a business’ value by calculating the present value of its predicted future earnings.
This method takes into account the present value of any terminal value the business may have (an indefinite stable growth rate). Thus, when calculating future cash flows, an assessor takes into account inherent risks in future investments.
Will your company undergo significant future growth? Then the discounted cash flow method may provide a clearer picture of its value than other methods that do not take into account future earnings.
Market value method
This method establishes your company’s value by looking at similar companies that have recently sold and comparing the value.
The market approach looks into data such as earnings, stock prices, and cash flow. These help to establish ratios that will relate your business to the similar comparison business. And the resulting ratios of these metrics are the market multiples.
The process is similar to what real estate agents undergo when they value a home. As a result, the market value method can be very effective. But the catch — of course — is that there have to be sufficient similar businesses to use for the comparison. Therefore, if you have a one-of-a-kind operation, this might not be the best business valuation method for you.
Dividend-paying capacity method
The divided-paying capacity method is an example of an approach for publicly held businesses. In this method, the assessor uses financial information regarding publicly traded securities from similar companies to calculate the market multiples.
This approach, however, also employs some qualitative data. It assumes that investor attitudes and expectations about other companies will also apply to the company undergoing the valuation. This would seem logical, but it is important to know that it does rely upon an assumption.
Transaction database method
The transaction database method is an example of a business valuation strategy for privately-held companies. This method also examines transactions from businesses in the same industry to determine the market multiples.
Preparing for a Business Valuation
As you can see, there are many business valuation methods available to any company wishing to undergo a valuation. As such, the specifics of your business and the reason you want a valuation would be the two major factors for your decision.
Whichever strategy you choose, we urge you to properly prepare for the business valuation.
You would do this by:
- setting aside enough time and resources
- compiling documents and information needed for the process
- hiring a professional to assist you in the valuation.
We Can Help you Choose Among the Business Valuation Methods
The team at Saddock Advisory has been helping our clients, business leaders just like you, solve problems and customize solutions for nearly four decades. We are here to help you understand and effectively complete the business valuation process.
So, if you’re ready to craft insights and strategies that go beyond numbers, get in touch with us today!
At Saddock Advisory, we can help determine if your business is financially healthy. Get in touch with us here to find out more.
Sources:
https://www.investopedia.com/terms/b/
https://corporatefinanceinstitute.com/resources/
https://www.securedocs.com/blog/
