Hey there, Welcome back again. Let us understand what business valuation is and its different methods. Let us get started.
Ever wondered what is a business valuation and why is it done? So, in simple terms, business valuation is nothing new but a general process that is conducted to determine the economic value for a particular company unit or the whole business. It is done to get answers to questions like what will be the sale value? It also helps in establishing partner ownership, taxation, and for carrying out various proceedings.
There are three valuation methods for a business which are as follows:
- The first one is Asset Value or Book Value:
- The asset value or book value method is the fair market value of the business assets minus total liabilities on its balance sheet. Counting all the cash, equipment, inventory, real estate, stocks, options, patents, trademarks, all add up in the total asset valuation of the business. Asset value is also useful as a lower limit for a valuation range, as it measures a business’s tangible assets. There are two practices used under this method as given below: –
- Going Concern
- Businesses that plan to continue operating without an immediate plan to sell should use the going-concern approach. This formula considers the business’s current total equity (assets minus liabilities). Going-concern approach is an asset-based approach to valuation.
- Liquidation value is the asset value discounted for a necessary sale. Investors and lenders may consider liquidation value for younger or potentially distressed companies. In other words, the liquidation value asset-based approach to valuation assumes that the business will no longer continue or is finished, and its assets need to be liquidated/sold. The value is based on the total cash (value) that can be received post the business is terminated. Liquidation value often amounts business assets to a value much less than the fair market value as it operates in a sort of urgency.
- The Discounted Cash Flow method, also known as the Income approach, determines the present value of future profits or earnings with its projected cash flow adjusted or discounted to the present value of the potential risk of the business (not meeting profit expectations). There are variations of the Discounted Cash Flow method that use dividend, free cash flow, or other measures instead of earnings. Usually, such calculations are conducted on the present value of the past five years of earnings adjusted for growth and future earnings beyond five years (known as terminal value), it requires significant detailed and careful calculations. A higher discount rate results in a lower value, which reflects a greater risk posed by the business.
- The Market Value method is a relative method or subjective approach to measuring a business’s worth. It compares the total value of a company with similar or peers within the same industry that have been sold.
- The problem with using the Market Value method is that it can incorporate many errors the market makes in valuing comparable companies as well as in the overall direction of prices. It is particularly challenging for sole proprietors because it’s difficult to find comparative data on the sale of similar businesses as sole proprietorships usually have varied individually owned businesses. To arrive at a value, price-to-earnings ratio (P/E) is used.
The various benefits of business valuation are as follows:
- Better knowledge of company assets: Did you know that while creating a business valuation, estimates are not acceptable? They are not acceptable because it becomes too general. Specific numbers need to be considered from the valuation process to begin. It is an important matter for all the business owners and stakeholders as it helps in obtaining insurance coverage, helps in reinvesting, and how much to sell off to reap profits.
- Company resale value: In any case, if you plan to sell off the company soon, then knowing its true value is very important. It is a long-term process and must be started even before the business is up for sale. The main reason being the company gets some more extra time before listing the business for sale in the open market. This process helps to know the resale value so that negotiation can be done for a higher price.
- Helps in obtaining a true company value: Knowing the true value of the business is important in deciding if it is worth selling the business. Not only does it help in obtaining the true value but also helps in projecting the company income and the valuation growth over the previous five years. Potential buyers are always interested to know whether the business has been regular and whether it has achieved consistent growth or not.
- Helps in acquisitions: When you know what your business valuation is, business owners can negotiate for a much higher sale. Business owners are expected to demonstrate the value as a whole. It must also be able to emphasize asset withholdings, how it has grown, also how it is further expected to grow.
- Access to new investors: When you lookout for new investors to fund your company and company growth, a proper valuation projection must be made so that it helps potential investors decide how it is going to provide them with a return on investment.
To conclude, once the business valuation is made, new goals must be set to increase the company’s value over the next few years. The comparison must be made every year to measure growth, loss, and to estimate any room for improvement. Knowing every component of the business is a must as it helps in providing invaluable information for business owners.
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Hope this information is useful. If you have any more doubts, feel free to reach out to us. All the best and happy learning.