Updated July 3, 2023
What is Business Valuation?
Business valuation is the way to determine how much a company is worth now and how much it could be worth in the future. The goal is to identify the intrinsic value of the business, which can be achieved through methods such as discounted cash flow (DCF) valuation, comparable company analysis, and other techniques.
It is similar to figuring out how much your house or car is worth when considering selling it or buying a new one. By performing valuation, companies can see where they stand financially and what they need to do to grow and succeed.
For instance, Apple’s valuation of $3.0 trillion in 2022 was based on an analysis of its revenue, earnings, and growth potential, allowing the company to make informed decisions about future investments and expansion.
When businesses want to know their worth, they usually hire experts (financial Analysts) to analyze all parts of their operations, including their finances, management, and market value. The experts use methods like looking at the company’s earnings, cash flows, and how similar companies are valued to determine what the business is worth.
They also look at the company’s management and its financial structure. They try to estimate how much the business will earn in the future and how much its brand, products, and services are worth to figure out its overall value.
Knowing a business’s value is super important for investors, entrepreneurs, or finance pros. It helps them make intelligent decisions and get better deals.
Business valuation is handy in many situations, like:
- Buying or selling a company
- Mergers & acquisitions
- Getting a loan
- Settling legal disputes
- Planning estates or partnerships
By valuing a business, companies can also plan for future growth and determine how to expand.
Business Valuation Methods & Approaches
There are several methods to value a business. Each different method may be more appropriate for a specific business or industry. Some of the most common methods include:
#1 Income Approach
It estimates the value of a business based on its expected future income.
Example: For example, if a company expects to generate $100,000 per year in cash flow, and an investor requires a 10% rate of return, the company’s valuation will be at $1 million ($100,000 divided by 10%).
A. Discounted Cash Flow (DCF) Analysis
This method estimates a business’s value by calculating the total present value of its future cash flows. By considering the cost of capital, inflation, and other factors, DCF analysis can accurately assess a company’s worth.
B. Capitalization of Earnings (CapE) Formula
This method calculates the value of a business based on its current earnings and capitalization rate. Earnings are the business’s net income, and the capitalization rate measures the return an investor expects on an investment.
#2 Market Approach
It estimates the business’s value on the sale prices of comparable companies.
Example: If a similar company sells for $10 million, another company with similar financials in the same industry may value around $10 million.
B. Market Multiple
This method compares one business to another similar industry and calculates a value based on a multiple of earnings/revenue or other financial metrics. Multiple is the average multiple of comparable companies, and Earnings or Revenue is the business’s financial performance metric.
C. Comparable Company Analysis (CCA)
It determines a company’s value by assessing the financials of a similar size business from the same industry. The most common ratio used under this method is Enterprise Value (EV)/ Earnings before tax, depreciation, and amortization (EBITDA)
#3 Asset Approach
It estimates the value of a company by evaluating its assets.
Example: If a company has $5 million in assets and $2 million in liabilities, its net worth would be $3 million.
A. Liquidation Value Method
In this method, we subtract the liquidation value of liabilities from the liquidation value of assets. It predicts the amount the company will earn if it sells all its assets immediately.
B. Net Asset Value
This method helps businesses evaluate the value of their business by assessing their total assets after deducting liabilities.
How to Calculate Business Valuation?
Here is a stepwise guide to business valuation:
#1: Analyze Financial Statements
- Analyze financial statements like income, balance sheets, and cash flows to check a company’s profitability.
- It involves analyzing the company’s assets, liabilities, income, expenses, and potential earnings to assess the overall health and value of the organization.
- You can also use the business’s 10K reports (Annual report) or refer to major websites like Yahoo Finance, Reuters, etc., for analyzing the company’s financials.
#2: Evaluate Other Factors
- Investors also consider the business’s dependence on its key personnel and vulnerability to external factors and intangible assets like intellectual property, brand recognition, and customer loyalty.
- It considers factors such as the cost of capital and risk factors such as competitive dynamics, economic climate, and the company’s legal environment.
#3: Build a Financial Model
- The business then creates a financial model to estimate the company’s performance over the next 5 to 20 years.
- Investors study the company’s historical financial performance and adjust it for inflation to estimate future profits.
- Additionally, comparing the company to similar recently sold businesses helps determine a realistic market value.
#4: Perform Valuation
- The analysts determine a fair price for the company or its target share price using various valuation techniques like DCF analysis.
- It helps investors evaluate whether the company is overvalued or undervalued and whether it is a good investment opportunity.
Business Valuation Example – Using DCF Valuation
Let’s take the hypothetical case of a software company XYZ Inc. Using the Discounted Cash Flow (DCF) method; we will illustrate the business valuation process.
XYZ Inc. has been operating for five years, and the management wants to determine the company’s fair market value. The financials of the company are as follows:
- Net income for the last fiscal year: $10 million
- Depreciation and amortization: $1 million
- Interest expense: $500,000
- Tax rate: 25%
- Capital expenditure: $2 million
- Cash and cash equivalents: $1 million
- Debt outstanding: $3 million
- EBIT: $13 million
Let us find out if the company is overvalued or undervalued using DCF analysis.
To carry out a DCF analysis, we must first forecast the company’s future cash flows. Let’s assume that the company will grow at a rate of 10% per year for the next five years, then grow at a rate of 5% after that.
Step #1: Calculate Free Cash Flow to Firm (FCFF)
First, let us calculate the FCFF for the first year,
= $13 million * (1 – 25%) + $1 million – $2 million – $0 = $8.75 million
FCFF for the rest of the years would be:
FCFF = FCFF (Previous year) * (1 + Growth Rate)
= $8.75 million x 1.10 = $9.63 million
Similarly, the FCFF for the other years is as follows:
Year 3 = $9.63 million x 1.10 = $10.59 million
Year 4 = $10.59 million x 1.10 = $11.65 million
Year 5 = $11.65 million x 1.10 = $12.82 million
As the growth rate changes from 10% to 5% after year 5, the FCFF for year 6 and after will be,
Year 6 and beyond = $12.82 million x 1.05 = $13.46 million
Step #2: Calculate Terminal Value
Next, we need to calculate the terminal value of the company XYZ, which represents the value of the company beyond the forecast period.
To do this, we can use the perpetuity growth formula, which assumes that the company will grow at a constant rate indefinitely:
Terminal value = [FCFn x (1 + g)] / (r – g)
- FCFn is the free cash flow in the last year of the forecast period
- g is the perpetuity growth rate
- r is the discount rate.
Let’s assume that the perpetuity growth rate is 2% and the discount rate is 12%. Thus the terminal value will be,
Terminal value = [$12.82 million x (1 + 2%)] / (12% – 2%)
= $130.76 million
Step #3: Calculate Present Value
Finally, we can calculate the present value of the forecast period cash flows and the terminal value using the discount rate:
Present Value = FV / (1 + r) ^ n
- FV is the Future Value.
- r is the Rate of Return.
- n is the Number of Periods.
1. Present Value of Forecast Period Cash Flows
First, we will calculate the present value for each forecasted year and then add them all to receive the present value of the forecasted period.
Present Value for year 1 = FCFF (year 1) / (1+ Discount rate) ^ n
=$8.75 million / (1+12%)^1 = $7.81 million
Similarly, the present value for the other years is as follows:
Year 2 = $9.63 million / (1+12%)^2 = $7.68 million
Year 3 = $10.59 million / (1+12%)^3 = $7.54 million
Year 4 = $11.65 million / (1+12%)^4 = $7.40 million
Year 5 = $12.82 million / (1+12%)^5 = $7.27 million
Total Present Value for forecast period = Sum of All present values
= $7.18 million + $7.68 million + $7.54 million + $7.40 million + $7.27 million
= $37.71 million
2. Present Value of Terminal Value
Present value (Terminal value) = Terminal Value / (1+Discount Rate) ^ Number of Period
= $130.76 million / (1 + 12%) ^5
= $74.20 million
Step 4: Calculate Enterprise Value
To calculate the enterprise value, we will add up the present value for both the forecast periods and the terminal value:
Total enterprise value = Present value of forecast period cash flows + Present value of terminal value
= $37.71 million + $74.20 million
= $111.91 million
Step 5: Calculate Equity Value
Let us calculate the equity value now using the following formula:
Equity value = Enterprise value – Debt Outstanding
= $114.91 million – $3 million
= $108.91 million
Based on our DCF analysis, the fair market value of XYZ Inc. is $108.91 million.
Step 6: Determine if Overvalued or Undervalued
Next, let us compare the fair equity value to its current market value to determine whether the company is undervalued or overvalued.
- Let’s say that the current market value of the company’s equity is $90 million. The company is undervalued by $18.91 million ($108.91 million – $90 million).
- Suppose the company’s equity value was $110 million. Then it is overvalued by $1.09 million ($110 million – $108.91 million).
Business Valuation Calculator
We have made a calculator that uses DCF valuation to value a business. You can use the following calculator for business valuations.
|Enterprise Value||NPV of explicit period + NPV of terminal value|
|=||0 + 0 = 0|
|Equity Value||Enterprise Value + Cash - Debt + Marketable securities, restricted cash|
|=||0 + 0 - 0 + 0 = 0|
|Target Share Price||Equity Value / Current shares outstanding|
|=||0 / 0 = 0|
Importance of Business Valuation
Business Valuation is important for several reasons:
- Investment Decisions: Understanding the value of a business helps investors determine if the company is a good investment opportunity. It helps in decision-making, whether for buying or selling a business, raising capital, or making investment decisions.
- Financial Planning: It guides business owners looking to sell their business, retire, or pass on the company to the next generation. It helps them understand the current worth of the business, which is essential for making informed decisions about their financial future.
- Mergers and Acquisitions: It is crucial in mergers and acquisitions as it helps determine the value of the target company, the transaction amount, and the deal’s structure. It also helps companies negotiate better terms and avoid overpaying for the target company.
- Taxation: It is crucial for tax purposes, including estate planning, gift tax, and capital gains tax. It helps ensure that businesses are taxed fairly and accurately based on their actual value.
- Maximizing Profits: Knowing their company’s value allows them to set a fair price for products or services to maximize their profits. It also helps owners and investors identify potential growth opportunities and risks.
Business Valuation Jobs
There are several job roles and positions in business valuation, including:
- Business Valuation Associate: This role involves conducting research and analysis to determine a company’s or business’s value. Valuation analysts typically use various methodologies, such as discounted cash flow, comparable company analysis, and asset-based valuation, to determine the value of a company.
- Investment Banker (IB): IBs advise clients on financial matters, including mergers and acquisitions, capital raising, and valuations. They use their expertise to analyze the financial performance of a business, determine its value, and negotiate deals on behalf of their clients.
- Certified Public Accountant (CPA): CPAs provide a range of accounting and financial services, including valuation. They may also work with valuation analysts or CBVs to provide financial analysis and reporting for a business.
- Chartered Business Valuator (CBV): CBVs are trained professionals who specialize in the valuation of companies. They provide independent, objective, and defensible opinions on a business’s value for various purposes, including mergers and acquisitions, litigation, and tax planning.
Business Valuation Salary
The salaries of various valuation job roles vary widely depending on location, years of experience, and specific industry or company. Here are some approximate salary ranges for different job roles based on data from various sources:
|Business Valuation Associate||$52,000 – $100,000||$68,000|
|Investment Banker||$56,000 – $250,000||$119,000|
|Certified Public Accountant (CPA)||$52,000 – $120,000||$73,000|
|Chartered Business Valuator (CBV)||$70,000 – $125,000||$87,000|
Business Valuation Books
Here are some highly-rated books on business valuation:
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company
- “The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit” by Aswath Damodaran
- “The Art of Company Valuation and Financial Statement Analysis: A Value Investor’s Guide with Real-Life Case Studies” by Nicolas Schmidlin
- “Investment Banking: Valuation, LBOs, M&A, and IPOs” by Joshua Rosenbaum & Joshua Pearl
- “The Handbook of Business Valuation and Intellectual Property Analysis” by Robert F. Reilly and Robert P. Schweihs.
Frequently Asked Questions (FAQs)
Q1. What are some real-life business valuation examples?
Answer: Here are some real-life examples of business valuation:
- Microsoft: Microsoft approximately values $2.5 trillion in 2022.
- Amazon: As of 2022, Amazon’s business is approximately $1.8 trillion
- Alphabet (Google): Google values at approximately $1.5 trillion
- Coca-Cola: In 2022, Coca-Cola was valued at $97.88 billion, an increase of $10.2 billion from $87.6 billion in 2021.
Q2. Define the rule of thumb in business valuation.
Answer: In business valuation, the rule of thumb is a quick, simple method that estimates a business’s value based on a benchmark. Rather than performing calculations on the financial statements, this method uses the industry benchmark or standard to determine the company’s value.
Some common rules of thumb include:
- Revenue multiple: It values the company as multiples of its revenue. For example, a business’s value might be three times its annual revenue.
- Earnings multiple: It values the company as multiples of its earnings. For example, a business might value at eight times its annual earnings (EBITDA).
- Price per customer: We can also multiply the number of customers a business has by the amount a customer brings in as revenue. For example, the cost per customer is $500 x 1000 customers equals $500,000 as the business’s value.
Q3. What is the industry multiplier for a business valuation?
Answer: The industry multiplier, also known as the price-to-earnings (P/E) ratio, is a valuation method that determines the value of a company. It divides the market value of a company by its earnings before interest, taxes, depreciation, and amortization (EBITDA). The multiplier value varies widely depending on the industry and the company. Generally, companies in industries with higher growth potential or greater profitability will have higher industry multipliers.
Q4. What is the cost of a business valuation?
Answer: Business valuations can cost as low as $2500 or as high as $50,000 per valuation. Some brokers might even provide valuations services for free to small business owners to build solid client relationships. The valuation cost depends on the revenue a business earns in a year. The lower the income, the lower the valuation cost, and vice versa.
Q5. Explain the income approach in business valuation.
Answer: The income approach in business valuation is a method that estimates the value of a business based on its future cash flows. It involves estimating future cash flows and discounting them back to their present value using a discount rate (the discount rate reflects the investment risk). Then, they arrive at an estimated value for the business. This approach is useful for companies with stable cash flows.
Q6. What is the business valuation formula?
Answer: There is no one-size-fits-all business valuation formula. The appropriate method for valuing a business will depend on several factors, including the size of the company, its industry, its financial performance, and growth prospects.
We have provided a comprehensive case study on the Business Valuation method using the Discounted Cash Flow (DCF) analysis. To understand the process in detail, please refer to the previous section titled “Calculate Business Valuation – Case Study Using DCF Analysis” in this article.
Q7. What is the best business valuation course? Where can I get business valuation certification?
Answer: There are numerous business valuation courses available online. Most of these courses also provide certifications to the learners. Some of these courses are free, and others cost starting from $100.
This was an EDUCBA guide to business valuation. Please refer to EDUCBA’s Recommended Articles to learn more about business valuation.