Business Valuation Guide
The best way to think of business valuation is as a process. You need to follow a number of steps starting with the definition of the task at hand and leading to the business value conclusion. The steps are:
- Planning and preparation
- Adjusting the company's financial statements
- Choosing the business valuation methods
- Applying the selected valuation methods
- Reaching the business value conclusion
Let’s take a look in detail what happens at each step.
Step 1: Planning and preparation
Much like running a successful business, effective business valuation requires planning and attention to detail. The two key starting points toward establishing your business worth are:
- determining why you need business valuation
- assembling all the required information
You may be surprised at first that your reasons for business valuation may affect the results you get. Isn’t business value absolute? Not really. True, you use business valuation to measure business worth objectively. But the outcome depends on two key elements: how you measure business value and under what circumstances.
Business value depends on how and why it’s measured
A couple of examples will illustrate this important point.
Let’s say you have decided it's time to sell your business. Business has been good, with revenues and profits growing each year. You plan to market the business until the right buyer is found. You want to pick the best offer and are not in a hurry to sell.
In this situation your standard of value is the so-called fair market value. Your premise of value is a business sale of 100% ownership interest, on a going concern basis. In other words, you plan to sell your business to the highest and best bidder and expect it to continue running under the new ownership.
Next let’s imagine that you own a small business that has developed a product of great interest to a large public corporation. They already approached you offering to buy you out. They have great plans for your product and want to sell it internationally. These people are even prepared to offer you some of their publicly traded stock. Your CPA tells you the offer price is right and the deal terms should help lower your taxes.
In this scenario you have a synergistic buyer who is applying the so-called investment standard to measure the value of your business. Buyers like that are often willing to pay a premium for a business they want. That's because they see unique advantages to be gained by business purchase.
Now consider a situation where the business owners need to settle a large bill with one of the business’ creditors who is tired of waiting. There is not enough cash in the bank to cover the amount, so business assets need to be sold quickly.
This is the case where the so-called forced liquidation premise of value may apply – business owners don’t have enough time to look for the best buyer and may have to settle on a quick auction sale.
Once you know how and under what conditions you will run your business valuation, it is time to gather the relevant data. This typically includes the business financial statements, operational procedures, marketing and business plans, customer and vendor information, and staff records.
What makes a company valuable?
Great question. Some points to consider:
You need to have well-documented financial statements and tax returns to demonstrate the business's earning power.
Steady, above industry norm earnings tend to translate into higher business value.
Detailed written business operating procedures make it easy to understand how the business works, who does what, and what skills are needed.
Since it is easier to take over a well-run and organized business, there is greater business buyer interest and competition among them tends to increase the business selling price.
A good marketing plan provides the essential inputs into the future business earnings projections. You need a reliable earnings forecast for business valuation.
A look at the sales by customer quickly shows where the business gets its revenues. Businesses that do not rely on a few large customers for most of their business sales tend to command a higher selling price.
Let’s say that the business enjoys an exclusive distribution agreement with a major vendor, a key competitive advantage. If this agreement can be transferred to the business buyer, the business selling price is likely to be higher.
Skilled and motivated staff is essential to business success. Not surprisingly, if experienced long-term employees stay with the business after the sale, the selling price is likely to reflect it.
Some info will shed light on business value right away. But the company’s historical financial statements need to be adjusted to run business valuation calculations. We discuss the financial statements adjustment process in the following sections.
Step 2: Adjusting the historical financial statements
Business valuation is an economic analysis exercise. Unsurprisingly, the company's financial performance offers key inputs into the process. The two main financial statements you need for business valuation are the income statement and the balance sheet. To do a proper job of valuation, you should have 3–5 years of historic income statements and balance sheets available.
Many business owners manage their businesses to reduce taxable income. Yet when it comes time to figure out what the company is worth, you need to emphasize the full business earning potential.
Since business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company historical financial statements may need to be normalized or adjusted.
The idea is to construct an accurate relationship between the business assets, expenses and the levels of business income these assets are capable of producing. In general, both the balance sheet and the income statement require normalizing adjustments for business valuation. Here are the most common ones:
Step 3: Choosing your business valuation methods
Once your data is ready, it is time to choose how you will calculate business value. Since there are a number of well-established methods to do it, it is a good idea to use several of them to cross-check your results.
All known business valuation methods fall under one or more of these fundamental approaches:
The set of valuation methods you choose depends on your particular situation. Here are some points to consider:
- The complexity and value of the company’s asset base.
- Availability of the comparative business sale data from the market.
- Business earnings history.
- Availability of realistic business earnings forecasts.
- Reliable estimate of the cost of capital given the risk profile of the business.
Choosing the asset based valuation methods
If you are dealing with an asset-rich company, you may have to handle the cost and complexity of the asset-based valuation methods, such as the asset accumulation. In addition to valuing the individual business assets and liabilities, the method can be helpful in purchase price allocation as part of the asset purchase agreement.
How the market based business valuation methods work
Market based business valuation methods focus on value estimation by examining the business sale transaction data available from the actual market place. There are two types of transaction data you can use:
- Guideline transactions involving similar public companies.
- Comparative transactions involving private companies that closely resemble the subject business.
The advantage of using the public guideline company data is that it is plentiful and readily available. However, you need to be careful to make an “apples to apples” comparison to a private company.
In contrast, reviewing business sales of similar private companies can offer an excellent and direct way for value estimation. The challenge is gathering sufficient and trustworthy data for a meaningful comparison.
Regardless of which market-based method you choose, the calculations rely on a set of so-called valuation multiples that help you assess value in relation to some form of the business's economic performance. Typical multiples used in business valuation include:
Each valuation multiple is a ratio of the likely business selling price divided by some economic performance factor. So, for instance, the selling price to revenue multiple is calculated by dividing the business selling price by its revenue.
To figure out your business value, you can use one or more of these multiples. For example, take the selling price to revenue multiple and multiply it by the business annual revenue.
Valuation multiple formulas
More sophisticated market based business valuation methods, such as the Market Comps in ValuAdder, use business pricing rules that make an intelligent choice of which multiplies to apply when valuing a business. In addition, the Market Comps let you account for key financial parameters such as:
The income based business valuation
Income based methods give you the way to determine business value based on the company's earning power and risk profile. Business valuation experts widely consider these methods to be the most accurate. All income based business valuation methods work by either discounting or capitalization of some measure of business earnings.
The discounting methods, such as the Discounted Cash Flow, produce very accurate results based on your forecast of the expected business income stream over time. The Discounted Cash Flow method is an excellent choice for valuing a young or rapidly growing company whose earnings vary considerably.
Alternatively, you can use the direct capitalization methods, such as the ValuAdder Multiple of Discretionary Earnings and Capitalized Earnings, to run your valuation based on the business earnings and a carefully constructed capitalization rate. Both methods are great choices for valuing established companies with stable earnings and growth rates.
Step 4: Number crunching: applying the selected business valuation methods
With the relevant data assembled and your choices of the valuation methods made, calculating your business value should produce results that are precise and easy to justify.
One reason to use several business valuation methods is to cross-check your numbers. For example, if one business valuation method produces surprisingly different results, it's time to review your inputs to see if anything has been overlooked.
ValuAdder business valuation software helps you focus on the big picture of determining the business value by automating complex calculations and letting you focus on your assumptions while running multiple what-if valuation scenarios.
Step 5: Reaching the business value conclusion
Finally, with the results from the selected valuation methods available, you can decide what the business is worth. This step in the valuation process is called the business value synthesis. Since no one valuation method provides the definitive answer, it is a good idea to combine the results you got into an overall opinion of value.
Your valuation methods may have produced different results. To draw your conclusion about the business value you need to reconcile these differences.
Business appraisers usually apply a weighting scheme to come up with the business value conclusion. You can assign weights to the method results in order to rank their relative importance in reaching the business value estimate.
Here is an example of using such a weighting strategy:
|Approach||Valuation Method||Value||Weight||Weighted Value|
|Market||Comparative business sales||$1,000,000||25%||$250,000|
|Income||Discounted Cash Flow||$1,200,000||25%||$300,000|
|Income||Multiple of Discretionary Earnings||$1,350,000||30%||$405,000|
The business value is just the sum of the weighted values which in this case equals $1,145,000.
While there are no hard and fast rules to determine the weights, many business valuation professionals use a number of guidelines to pick the weights for their business value conclusion:
The Discounted Cash Flow method results warrant higher weights in the following situations:
- Reliable business earnings projections exist.
- Future business income is expected to differ substantially from the past.
- Business has a high intangible asset base, such as internally developed products and services.
- 100% of the business ownership interest is being valued.
The Multiple of Discretionary Earnings method gets weighted heavier when:
- Business income prospects are consistent with past performance.
- Income growth rate forecast is deemed reliable.
Market based valuation results are weighted more whenever:
- Relevant and recent data on comparable business sales is available.
- Minority (non-controlling) business ownership interest is being valued.
- You need selling price justification.
The asset based valuation results are emphasized in the weighting scheme when:
- Business is exceptionally asset-rich.
- Detailed business asset value data is available.