Business Valuation Methods

Business Valuation

Simply put, business valuation is a set of procedures and complete processes used for determining the real worth of a business. While this may sound pretty easy, getting your business properly valued calls for preparation and thought.

Business Valuation Certification

Business valuation certification of the process to value a company is carried out only at the time of selling or buying the business. Frankly speaking, business valuation certification is a versatile tool which has a great impact on the action of managers. When used as a business performance indicator, a business valuation certification can demonstrate which direction the business is heading. It identifies which strategy is working best from the business perspective. Companies that have several subsidiaries, have to decide how to distribute their resources. Valuation is a major part of the filtration process. Business valuation certification units showing the largest growth value and making a bigger contribution to the total value should ideally receive a greater slice of the resources pie.

Business valuation certification is also an important management motivation tool. Balance sheets and profit and loss statements can often forge an incorrect picture of the true worth of a business. Much accounting jugglery is involved in preparing financial statements. They include many components that have little or no realizable worth. Managers, who rely on these numbers, may be unaware of leading the company to trouble. Valuation, here, is a “checking mechanism” used in addition to the conventional formats. It’s also a useful yardstick for assessing the industry’s life cycle position. If the value of the business drops over time, the management can check whether more resources are required for maintaining the market position. It may reveal that demand in that particular industry is wavering.

The industry may have topped out and about to decline. A timely exit will ensure a more worthy price for the business and can also eliminate the chances of major losses. A steady increase in value, on the other hand, could signal that the industry is in the growth stage. It’ll give the management confidence to scour for market penetration opportunities. The most important aspect is to utilize business valuation as a performance indicator and can be carried out by companies irrespective of their size. It has universal relevance and broad scope.

Business valuation is a corporate-wide analysis which achieves a general picture of a company’s position in terms of the market and the industry. The versatility of business evaluation means it can complement the existing management tools as well as serve as a filtering process for project appraisal exercise.

But the method used in business valuation is exceptionally important. The analysis has to be transparent and at the same time consider external influences. The processes should be understood by all parties involved.

Why business valuation?

There are many reasons to carry out a business valuation. Here are some of them.

• Commencing a sale of your business
• Resolving stakeholder disputes
• For future decision making and business planning
• Fixing tax obligations
• Litigation
• Accessing external funding sources

Business valuation calculator

Preparing a business valuation is to calculate before starting selling off the company is a major step to understand the real value of your business. If properly carried out, it will reveal accurate numbers and the price that you can expect to achieve. It’s often the beginning of all future negotiations. It’s also a reconnaissance for those who are not in line with the present market situation. In such cases, a candid assessment gives the correct means to take decisions i.e. go ahead with the sale, or improve the business valuation for a calculate in the future.

There could be times when a shareholder may want to leave the business. It could be a cordial parting where the person wants to move on or may stem from years of disagreement. A departure usually entails one party selling of his/her stake to the other shareholders. Determining a fair price of the shares for a departing stakeholder could be challenging. An externally prepared business valuation is an appropriate starting point in such cases.

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Business planning

All proprietors must be aware of the market value of their business for forwarding planning. This is particularly important during expansions, to know whether it’ll be at all worthwhile. Understanding the present position of the business will help owners take important decisions about the future of their business.

The results depend on your assumptions

For one thing, there’s no one way to determine what a business could be worth. That’s because a business valuation could mean different things to different people. While the proprietor of a business may believe that the community it serves has a lot of worth, an investor may think, the value of a company is totally defined by the historic income. Besides, economic conditions often affect people’s belief in the worth of a business. For instance, when job opportunities are scarce, more business buyers prefer to enter the market. It leads to increased competition which in turn results in a higher business selling price.

The value of a business is also affected by the selling circumstances. There’s a huge difference between a company that’s projected as a part of a well-planned branding mechanism to attract interested buyers than a prompt auction of business assets.

Business value and expected selling price

Business value, in real terms, is the expected price a company would fetch while selling. The actual price may vary depending on who fixes the value. The selling price is also dependent on how the sale itself is handled. There’s a difference between a well-executed marketing campaign and a “flash sale”.

Business valuation methods

There are three methods of business valuation are given below:

1. Asset approach

In this Business valuation methods, the business is viewed as a set of liabilities and assets i.e. the building blocks to determine the real business value. Business valuation methods are based on the so-called economic rationale of substitution which asks the question: What will be the cost to set up another similar business, like the one being valued, which will create the same economic benefits for its owners?

All operating businesses have their assets and liabilities. Determining their value would be the most natural way to evaluate the business. The difference between the assets and liabilities will be the final value, either positive or negative.

While it may sound simple enough, the real challenge is to figure out which liabilities and assets to consider for valuation and choosing a standard to measure their value. The actual determination of each liability and asset comes next.

Balance sheets, for instance, may not include the more important assets like indigenously manufactured products and proprietary methods of carrying out business. If the proprietor didn’t pay for them, they won’t be recorded on the balance sheet.

But the real value of these assets is often greater than that of all “recorded” assets combined. Imagine a company that has no special products or services but still manages to attract customers.

2. Market approach

As the name implies, the market approach depends on the signs of the actual marketplace for determining the worth of a business valuation. The economic principle of competition is applicable here.

What is the worth of other business valuation that are providing the same products and services as my business?

No company can operate in a vacuum. If you have a unique product or service, chances are, there will be competitors in the market offering a similar or largely similar thing. If you want to buy a company, you have to zero in on the type of business that interests you and then do some market survey regarding the “going rate” for the business type.

On the other hand, if you want to sell your business, check out the market rate on what similar businesses are selling for.

It’s intuitive to believe that the “market” would settle to an idea of business-price equilibrium, where the buyers are willing to pay what the sellers are ready to accept. This is also known as the fair market value. Here, both parties assume to act in full awareness of all relevant facts. Neither side is compelled to close the sale.

The market approach to evaluating a business valuation is one of the best to determine the fair market value, which is a monetary value, likely to be exchanged at an arms-length transaction, with the seller and buyer acting in their best interests. The market data is very helpful to support your offer or the asking price. If the “going rate” is this much, why should you accept less or offer more?

3. Income approach

This approach takes a look at the key reason to run a business i.e. generate revenues. If you invest your money, time, and energy into owning the business, what economic benefits will you derive from it? The expected economic benefit from the purchase or sale is important. Since the money is yet to come in the bank, there’s some amount of risk, of not receiving a part when you expect it. To determine the kind of money the purchase/sale may bring, the income valuation method factors in this risk. Since the valuation of the business must be taken in the present time, the expected risk and income must be translated in the current time. The income approach uses capitalization and discounting as the two methods in this regard.

The capitalization method, in its simplest form, divides the expected earnings from the business by the so-called capitalization rate. The underlying rationale is that business value is defined by earnings and the capitalization rate is used for relating the two.

For instance, if the rate of capitalization is 20% then the business is valued at five times its annual earnings. The capitalization factor is the other way which is used for multiplying the income. Either way, the result is what the business is valued today.

The discounting method works differently. First, you project the income stream of your business for a period of time in the future, which is usually measured in years. Next, determine the rate of discount that reflects the risk of generating the income on time.

Lastly, figure out the worth of the business at the end of the projection period. This is also known as the terminal or residual value of a business. The discounting calculation reveals what the business is worth today.

Business valuation and risk

Both methods of income valuation do the same thing, and you can expect identical results. In fact, discount and capitalization rates are co-related.

CR=DR-K

Here CR is the capitalization rate, DR is the discount rate, and K represents the average expected growth in income. For instance, if the rate of discount is 25% and the projected profits are a steady 5% every year, then the rate of capitalization is 25-5=20%. The income input used is perhaps the biggest difference between the discounting and capitalization method. Capitalization considers a single income measure like the average earnings for the past few years. Discounting is done on income values, one for every year in the projection period.

If your company earns steady profits for years on end, the capitalization approach could be a good choice. Growing businesses witnessing less predictable profits, the discounting approach will give more accurate results.

How results differ according to business valuation methods?

Can different business valuation methods reveal different results? Yes, absolutely. Consider two prospective buyers carrying out income projections to assess the risk to own a given business. Every buyer will have a different perspective on the risks involved. Their discount and capitalization rates are likely to differ. Besides, the two buyers will have their respective plans for the business that will affect the income stream projection.

Even if the two buyers use similar valuation methods, the outcome could be different from one other. Putting it in another way, the investment value standard determines the worth of a business. The buyers would measure the business value differently, depending on their investment objectives and ownership.

The flexibility to measure the worth of business for matching one’s objectives is arguably the greatest strength of the income valuation approach.

Related Article

This has been a guide to Business valuation which is corporate-wide analysis to achieves a general picture of a company’s. Here we also discuss the 3 methods of Business Valuation along with Calculator and certification. You may also look at the following articles-

1. Sales Promotion Types
2. Business Startup Mistakes to Avoid
3. Funding Requirements
4. Consumer Behavior