Determining a company’s fair market value is a critical finance skill for business leaders in a dynamic marketplace. How do finance professionals evaluate assets to find a single number for a company’s value?
Whether you’re buying, selling, or planning strategically, understanding valuation is crucial. Here are some common financial terms and valuation techniques used to assess businesses, determine how to value a business and explain why some companies are highly valued.
What is Business Valuation?
Business valuation assesses a company’s total economic worth. This process reviews all business aspects to find its current value, which is usually a range. Valuations are important for reasons like determining sale prices and tax reporting.
The Importance of Business Valuation
A business valuation is crucial for a variety of reasons including when seeking investment, selling, merging, or buying a company. It gives a clear view of your business’s market value. Knowing your business’s value helps you set a fair price, negotiate well with buyers, and get good financing deals. An accurate valuation also guides the long-term financial health of your business. It highlights your company’s strengths and weaknesses, aiding in strategic decision-making.
What Do You Need to Value a Company?
Here are steps to guide you through the business valuation process.
Prepare Your Business Information
You need specific business information to value your business correctly. If preparing your documents is challenging and hiring a professional is not an option, ask friends or family with bookkeeping or business experience for help. When selling a business, buyers might want to do their own valuation, so keep your business documents organized and current. Ideally, you will need the following information.
Finances and Assets
Your financial statements for the last 2-3 years, including cash flow, debts, annual turnover, and profit and loss reports.
Information about physical assets like machinery, buildings, equipment, and stock.
Details of other assets, such as business goodwill and intellectual property, including protected designs or ideas.
A clear understanding of future growth plans and forecasts is also critical.
Legal Information
Legal documents include leases and insurance policies. Registration papers involve business name certificates, registration papers, licenses, permits, and other documents showing compliance with government requirements.
Business Profile, Procedures, and Plans
Market conditions include competitor details and how your business compares.
Sales information covers reports and forecasts.
Business history notes the start date, ownership, and location changes.
Business procedures include marketing, staff schedules, and customer service guidelines.
The business plan outlines marketing, emergency management, and growth strategies.
Other details include opening hours and whether premises are owned or leased.
Staff, Supplier, and Customer Information
Employee details include job descriptions, skills, experience, work history, performance reviews, and pay rates. Supplier details cover supply agreements and prices. Customer details involve customer numbers, profiles, and direct marketing activities.
Decide Whether to Get Professional Advice
It is always recommended to seek professional advice from a specialised business valuation professional (such as bizval), your accountant, or business advisor, to value your business. They can analyze finances, identify market trends, calculate goodwill, estimate future profits, and determine your business’s worth. They might also have clients interested in buying, saving you advertising costs and hassle.
Choose a Valuation Method
There isn’t a single set method for valuation. You can combine several methods to determine the final value. It’s possible you’ll need to agree on the valuation method with a buyer or investor. A professional can assist in deciding the best method for your business. Some common ways to calculate business value include discounted cashflow method, current market values, return on investment, business asset value, cost of building a business from scratch, and future profit potential.
Methods to Determine The Value of the Business
There are many ways to value a company. Each method offers a different perspective, and no single approach is universally correct.
Book Value
This is the shareholders’ equity value listed on the balance sheet. Calculate it by subtracting total liabilities from total assets. This is a fairly crude and simple method and seldom used in practice.
Discounted Cash Flows
The DCF method for valuing a business is a common method used by business valuers and investment professionals alike.It uses future cash flow projections to determine a company’s current market value. Unlike the profit multiplier method, DCF accounts for inflation when calculating present value.
Market Capitalization
Market capitalization is a straightforward way to value a business. It is calculated by multiplying the company’s share price by the total number of shares outstanding. As of August 9, 2024, Microsoft Inc. had a share price of $406.02. With 7.43 billion shares outstanding, the company’s valuation was about $3 trillion. This is typically used for listed companies, as such comparative information is not always available for private companies.
EBITDA based multiples
Financial analysts prefer EBIT over raw net income as it’s less manipulated by accounting conventions. Taxes and interest payments can distort a company’s true success. Depreciation and amortization impact earnings without actual cash spent, often making growing companies like Amazon and Tesla appear less successful. EBIT adds back these factors. Calculating EBITDA helps analyze a company’s financial ratios more accurately.
Present Value of a Growing Perpetuity Formula
These ratios can be viewed in the context of the growing perpetuity equation. A growing perpetuity is a financial tool that provides annual payouts, which increase each year. Think of it as a retirement stipend that rises annually to keep up with inflation. This equation helps calculate the current value of such an instrument. To find the value of a growing perpetuity, divide the cash flow by the difference between the cost of capital and the growth rate.
Value of a Growing Perpetuity = Cash Flow / (Cost of Capital – Growth Rate)
FAQs
How does the business valuation process work?
The valuation process determines the current worth of a business. It examines all aspects, such as the company’s management, capital structure, future earnings, and the market value of its assets.
What is the formula for business valuation?
There are a number of different valuation methods. The 3 primary methods are: Discounted cash flow; Earnings multiple and Net Asset Value methods. bizval’s express calculator can give a reasonable estimated range in minutes.
How many times profit is a business worth?
A business is sometimes valued based on a multiple of its yearly profit. This value can change based on different factors. A business might be valued at anything from at anything 3-10 times its annual profit. One must exercise caution with this method and it is best used as a sanity check rather than a core valuation methodology.