Business Valuation Approaches That Every Founder Should Know
Business valuation is the process of determining the economic value of a business or company. This value can be used for various purposes, such as setting a selling price for the industry, determining the value of a company for a merger or acquisition, or determining the value of a company for estate or tax planning purposes. This article looks at common business valuation approaches and common business valuation methods.
Business valuation has become common for several reasons:
- Increased global competition: As the global economy has become more interconnected, businesses have had to compete with other companies worldwide. As a result, they need to know the value of their business to compete effectively.
- Growth in the number of small businesses: The number of small businesses has grown significantly in recent years, and many of these businesses need to know their value to make critical financial decisions.
- Increase in mergers and acquisitions: The number of mergers and acquisitions has increased in recent years, which has led to an increased demand for business valuations.
- Advancements in technology: Advances in technology have made it easier for businesses to access the information they need to conduct a business valuation, making the process more accessible and more common.
Purpose of Business Valuation
Before we dive deeper into the business valuation approaches, let us look at the purposes of business valuation. One of the primary purposes of business valuation is to raise capital. When a business owner wants to raise money from investors, they will often need to provide a valuation of their business to demonstrate its worth. This is particularly important for startups and small businesses that need capital to grow and expand.
Another purpose of business valuation is to facilitate mergers and acquisitions. When two companies are considering merging or one company is considering acquiring another, both parties must agree on the business’s value. A valuation can help facilitate this process by providing a neutral, third-party assessment of the company’s value.
Business valuation also plays a vital role in employee stock options. Many startups offer their employees stock options as a form of compensation; to do this, the company needs to know the value of the stock they are offering.
Business valuation also plays a vital role in estate and tax planning. When business owners want to pass their business on to their children or other heirs, they need to know the company’s value for estate tax purposes. Similarly, business owners need to know the value of their business for tax planning purposes.
In some cases, business owners may also need to get their business valued as part of a legal dispute, such as a divorce or a shareholder dispute.
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Business Valuation Approaches: An Overview
There are several different approaches to business valuation, including:
- Income approach: Analyses the business’s financial performance and future earning potential. Uses financial information such as income and cash flow statements to project future earnings and determine the present value of those earnings.
- Market approach: Compares the business to similar businesses that have been sold in the past. Uses information on comparable transactions, such as sales of similar companies or the sale of similar assets, to determine the value of the business.
- Asset-based approach: Values a business based on the value of its assets, such as property, equipment, and inventory. Also known as the cost approach, this approach determines the value of a business by estimating the cost to replace the business’s assets.
Income Approach
The income approach to business valuation is a method that values a business by analysing its financial performance and future earning potential or net income. This method uses financial information, such as income and cash flow statements, to project future earnings and determine the present value of those earnings.
The income approach is based on the idea that a business’s value is equal to its future income’s present value. It calculates the future income stream and then applies a discount rate to account for the time value of money and the level of risk associated with the business.
This approach is commonly used when valuing a business with a steady income stream, such as a service company or a retail business. It is also helpful in valuing businesses that have predictable cash flows and stable growth patterns.
The income approach to business valuation can be divided into the Capitalisation of Earnings method and the Discounted Cash Flow method.
Capitalisation of Earnings Method
The Capitalisation of Earnings method is a technique used to value a business using the income approach. This method values a business by dividing a measure of its earnings, such as income or cash flow, by an appropriate capitalisation rate.
The Capitalisation of Earnings method is based on the principle that a business’s value equals its future income’s present value. This method uses financial information such as the company’s earnings and dividends to estimate the value of the business.
The capitalisation rate is a measure of the risk associated with the business and is used to adjust the projected earnings for the level of risk. A higher capitalisation rate will result in a lower value for the company, and a lower capitalisation rate will result in a higher value for the business.
The Capitalisation of Earnings method is typically used when valuing businesses with predictable and stable income streams. This method is relatively easy to use and understand but has a few limitations. For example, it doesn’t consider the company’s growth potential or future cash flows.
To use the Capitalisation of Earnings method, the following steps should be taken:
- Identify a measure of earnings, such as income or cash flow
- Choose an appropriate capitalisation rate
- Divide the extent of earnings by the capitalisation rate to obtain the value of the business.
It is important to note that the Capitalisation of Earnings method does not consider other factors, such as the company’s assets, liabilities, or future growth prospects. Therefore, it is often used in conjunction with other valuation methods to get a more accurate estimate of the value of a business.
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Discounted Cash Flow Method
The Discounted Cash Flow (DCF) method is a technique used to value a business using the income approach. This cash flow valuation method projects the future cash flows of a company and then discounts them back to the present to estimate the value of the business.
The DCF method is based on the principle that the value of a business is equal to the present value of its future cash flows over a period of time. This method considers the company’s future growth, profitability and income potential and is considered more accurate than other methods, such as the Capitalisation of Earnings method.
The discounted cash flow valuation involves three main steps:
- Projecting future cash flows – Estimate the future cash flows of a business by estimating revenues, expenses, and capital expenditures.
- Choosing an appropriate discount rate – The discount rate is a measure of the risk associated with the business and is used to adjust the projected cash flows for the level of risk.
- Discounting the future cash flows to present value – Using the chosen discount rate, calculate the current value of the projected cash flows.
The DCF method is relatively complex and requires a lot of data and assumptions. It’s considered one of the most accurate methods, but it also has limitations, such as the subjectivity of the assumptions used and the difficulty of predicting future cash flows.
Asset Approach
The asset-based approach to business valuation is a method that values a business based on the value of its assets, such as property, equipment, and inventory. This method looks at a company’s tangible assets to determine its value.
The asset-based approach is based on the principle that a business’s value is equal to its assets minus its liabilities. This method values a company by determining the value of its assets, such as property, equipment, and inventory, and subtracting the value of its liabilities.
The asset-based approach is commonly used when valuing businesses with significant tangible assets, such as manufacturing or real estate companies. It is also helpful in valuing businesses that have little or no income but have valuable assets, such as a company that owns valuable patents.
The asset-based approach can be divided into the book value method and the market value method.
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Book-Value Method
The book value method is a technique used to value a business under the asset approach to business valuation. This method calculates a business’s value by determining its assets’ value as they are recorded on the company’s balance sheet.
The book value method is based on the principle that a business’s value is equal to its net assets’ value. This method values a company by determining the value of its assets, such as property, equipment, and inventory, and subtracting the value of its liabilities.
The book value method is relatively easy to use and understand, using the financial information already recorded on the company’s balance sheet. However, it has a few limitations, such as the fact that it doesn’t consider the asset’s market value. This means that the value calculated using the book value method may differ from the assets’ actual value.
To use the book value method, the following steps should be taken:
- Obtain the company’s balance sheet
- Determine the value of the company’s assets, as they are recorded on the balance sheet
- Determine the value of the company’s liabilities, as they are recorded on the balance sheet
- Subtract the value of the liabilities from the value of the assets to obtain the company’s book value.
It is important to note that the book value method is not the only method used to value a business and may not be appropriate for all types of companies. For example, it is not suitable for companies with significant intangible assets or companies that have recently undergone major changes in their operations or financial conditions.
Market Value Method
The market value method is a technique used to value a business under the asset approach to business valuation. This method calculates a business’s value by determining its assets’ market value.
The market value method is based on the principle that a business’s value equals the market value of its assets minus its liabilities. This method values a company by determining the current market value of its assets, such as property, equipment, and inventory, and subtracting the value of its liabilities.
The market value method is considered more accurate than the book value method as it considers the current market value of the assets. This means that the value calculated using the market value method is more likely to be the actual value of the assets.
To use the market value method, the following steps should be taken:
- Determine the current market value of the company’s assets, such as property, equipment, and inventory
- Determine the value of the company’s liabilities
- Subtract the value of the liabilities from the market value of the assets to obtain the company’s market value.
It’s important to note that the market value method is not always easy to use as it requires access to accurate market data, and it may be challenging to find accurate market prices for certain assets. Additionally, this method also requires the assumption.
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Market Approach
The market approach to business valuation is a method that compares the business to comparable companies that have been sold in the past. This method uses information on comparable transactions, such as sales of similar companies or the sale of similar assets, to determine the value of the business.
The market approach is based on the principle that supply and demand market forces determine a business’s value. This method uses information on past transactions of similar companies to estimate the value of the business.
The market approach is commonly used when valuing businesses similar to others sold. For example, it helps value small businesses or comparable real estate properties in the same industry.
The market approach can be divided into the guideline public company method and the guideline transaction method.
The guideline public company method compares the business being valued to publicly traded companies in the same industry. This method uses financial information, such as publicly-traded companies’ market capitalisation, to estimate the subject company’s value.
On the other hand, the guideline transaction method uses information on past transactions of similar businesses to estimate the value of the business being valued. This method is considered more accurate than the guideline public company method as it uses information on actual transactions of similar businesses.
In summary, the market approach to business valuation is a method that compares the business to similar businesses that have been sold in the past. This method uses information on comparable transactions, such as sales of similar companies or the sale of similar assets, to determine the value of the business. It’s commonly used when valuing businesses identical to others that have been sold in the past.
How Can KayOne Help?
Are you looking to sell your business or raise capital but don’t know its value? Look no further! Our team of experienced business valuators can help you determine the true worth of your business.
Our team utilises various income, market, and asset-based approaches to provide an accurate and comprehensive valuation of your business. We consider factors such as your industry, financial performance, and growth potential to give you a clear picture of the value of your business.
Don’t leave your business’s value to chance. Contact us today to schedule a consultation, and let us help you make informed decisions about your business’s future.
