Business Valuation Methods: Five Steps to Establish Your Business Worth

Business Valuation is the key to determining the value or worth of a business. In this fast-changing economic climate, every business needs to have an up-to-date business valuation on hand at all times. Even if your business was valued only a year ago, it probably won’t have the same value today as business values go up and down. Therefore, it has become imperative to keep a close track of business ‘value.

Business Valuation gives the ability to owners to create a practical timeline for the potential sale of the business and for other exit strategies. It provides a road map about how to adjust their short-term or long-term business goals and when to pull back in certain sectors or push forward in another.

Following are the five steps that can help you to establish your business worth

1. Planning and Preparation

 

Just as effective planning and preparation lead to running a successful business, Attention to detail and careful organization of information leads to successful business valuation. The two key factors in establishing your business worth are

 

• Determining the need for a valuation.
• Assembling all imperative information

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2. Adjusting the financial statements

 

Business Valuation is basically an economic analysis of a company. The company provides financial information as key inputs into the process by deriving inputs mainly from the two financial statements income statement and balance sheet. As business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company’s historical financial statements need to be adjusted. The aim is to construct an accurate relationship between the required business assets, expenses and the levels of business income assets are capable of producing. Therefore, for an accurate valuation of a business, 3-5 years of historical income statements and balance sheets need to be adjusted.

3. Choosing the business valuation methods

 

Applying the appropriate business valuation method or approach is very crucial for the successful business valuation of a business. There are mainly three business valuation approaches: –

• Asset Approach
• Income Approach
• Market Approach

Under each of the three approaches to determine business value, there are a number of procedures called Business Valuation Methods which are used to calculate business value. Each business valuation approach offers a different view of what a business is worth because of the difference in procedure and mathematical details of each business valuation method

 

1. Asset Approach

 

The asset approach considers the assets and liabilities as building blocks of the business to construct the picture of business value. Under the asset approach, the value of a business is determined by determining the value of assets. The aim is to determine the value of a business based on the fair value of assets minus liabilities. Methods under the asset approach are: –

 

Asset accumulation method.

There are two bases on which asset-based business valuations can be done

• Going concerned asset-based approach gives the business’s net balance sheet value of its assets and subtracts the value of its
• The liquidation asset-based approach assumes that all assets were sold and liabilities paid off. Then what would be the net cash?

 

2. Income Approach

 

The income approach determines the value of a business based on its income-producing capacity and risk. Under the income approach, there are two business valuation techniques capitalization and discounting. Discount and Capitalization rates capture the risk involved in a business. The income approach determines the fair market value of a business by measuring the current value of projected future cash flows. It derives this value by multiplying the cash flow of the company by its appropriate discount rate. The most commonly used business valuation methods are: –

• Discounted Cash Flow.
• Multiple of discretionary earnings
• Capitalization of earnings.

 

3. Market Approach

 

Under the market approach, the business value is indicated in comparison to historic sales involving similar businesses. The business valuation methods under the market approach are: –

• Comparative transaction method.
• Guideline publicly traded company method

Both the above methods work by comparing the subject company to a similar company that is sold recently. The business valuation method under the market approach relies on pricing multiple which determines the relationship between business economic performance and its potential selling price. Pricing multiple is determined by the sales of businesses that closely resemble the business being valued. Statistical analysis of such actual business sale data is used to establish the business valuation Market comparable.

 

4. Applying the selected valuation method

 

Once the financial statements are carefully compiled and adjusted, the selected business valuation method should calculate accurate business value. Calculating the business value using several business valuation methods helps to cross-check your assumptions.

 

5. Reaching the business value conclusion

 

After calculating the value from the selected valuation methods, we can make the decision of what the business is worth. This is called business value synthesis. As no valuation method provides the definitive answer, we can use results from different business valuation methods available to form opinions of actual value or worth of business. Different business valuation method produces different results, therefore concluding business value demands these differences to be reconciled.

 

Deriving a business value conclusion requires using a weighing scheme for various business valuation methods. The weights assigned to the results of various business valuation methods serve to rank their relative importance in reaching the business value conclusion.

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Since there are no defined set of rules for determining the weights, business valuation experts use a no of guidelines while selecting the weights for their business value conclusion: –

The asset-based approach is given emphasis in the weightings when: –

• Business is asset-rich.
• Detailed business asset value data is available.

The income-based approach is given emphasis in the weightings when: –

• Business earnings projections exist.
• Future business is expected to differ substantially.

The market-based approach is given emphasis in the weightings when: –

• Relevant comparable business sale data is available.
• Minority(non-controlling) business ownership interest is being valued.

Author: Shweta