What is a business valuation?

Business valuation, the term is used most often for discussions of sale or purchase of a business. Or when it comes to selling a business, the most important question you need to ask is – how much is it worth? – What a business is worth.

As such, there are no precise ways to value a private business, as the seller will want to drive the price up, and potential buyers will want the opposite. Although there are relatively easy ways to value tangible elements of the business – such as stock, fixed assets (land, machinery, equipment, etc.), but there may well be a sizeable intangible element to the value of a business.

Intangible elements would include "Goodwill" – this could include trademarks, reputation, branding, key people, the size and quality of the customer base. Valuing the potential value of a business is notoriously difficult to value, and in many cases will come down to how keen a potential buyer is to acquire the business in question.

When looking at the overall value of a business, there are numbers of different valuation methods which are commonly used – from using earnings multiples, to calculating how much it would cost to create a similar business.

Here are some common Business Valuation methods

• Adjusted Book Value
  
  One of the least controversial valuation methods. It is based on the assets and liabilities of the business.
• Asset Valuation
  
  Often used for retail and manufacturing businesses because they have a lot of physical assets in inventory. Usually it is based on inventory and improvements that have been made to the physical space used by the business. Discretionary cash from the adjusted income statement can also be included in the valuation.
• Capitalization of Income Valuation
  
  Frequently used by service organizations because it places the greatest value on intangibles while giving no credit for physical assets. Capitalization is defined as the Return on Investment that is expected. In a nutshell, one ranks a list of variables with a score of 0-5 based on how strong the business is in each of those variables. The scores are averaged for a capitalization rate which is used as multiplication factor of the discretionary income to arrive at the business' value.
• Capitalized Earning Approach
  
  Based on the rate of return in earnings that the investor expects. For no risk investments, an investor would expect eight percent. Small businesses usually are expected to have a rate of return of 25 percent. Consequently, if your business has an expected earnings of $50,000, its value might be estimated at $200,000 (200,000 * 0.25 = 50,000).
• Cash Flow Method
  
  Based on how much of a loan one could get based on the cash flow of the business. The cash flow is adjusted for amortization, depreciation, and equipment replacement, then the loan amount calculated with traditional loan business calculations. The amount of the loan is the value of the business.
• Cost to Create Approach
  
  Used when the buyer wants to buy an already functioning business to save start up time and costs. The buyer estimates what it would have cost to do the startup less what is missing in this business plus a premium for the saved time.
• Debt Assumption Method
  
  Usually gives the highest price. It is based on how much debt a business could have and still operate, using cash flow to pay the debt.
• Discounted Cash Flow
  
  Based on the assumption that a dollar received today is worth more than one received in the future. It discounts the business's projected earnings to adjust for real growth, inflation and risk.
• Excess Earning Method
  
  Similar to the Capitalized Earning Approach, but return on assets is separated from other earnings which are interpreted as the "excess" earnings you generate. Usually return on assets is estimated from an industry average.
• Multiple of Earnings
  
  One of the most common methods used for valuing a business. In this methods a multiple of the cash flow of the business is used to calculate its value.
• Multiplier or Market Valuation
  
  Uses an industry average sales figure from recent business sales in comparable businesses as a multiplier. For instance, the industry multiplier for an ad agency might be .75 which is multiplied by annual gross sales to arrive at the value of the business.
• Owner Benefit Valuation
  
  Computed by multiplying 2.2727 times the owner benefit.
• Rule of Thumb Methods
  
  Quick and dirty methods based on industry averages that help give a starting point for the valuation. While not popular with financial analysts, this is an easy way to get a ballpark on what your business might be worth. Many industry organizations provide rule of thumb methods for businesses in their industry.
• Tangible Assets (Balance Sheet) Method
  
  Often used for businesses those are losing money. The value of the business is based essentially on what the current assets of the business are worth.
• Value of Specific Intangible Assets
  
  Useful when there are specific intangible assets that come with a business that are highly valuable to the buyer. For example, a customer base would be valuable to an insurance or advertising agency. The value of the business is based on how much it would have cost the buyer to generate this intangible asset themselves.

Conclusion

You business may be a goldmine, but a business is only worth what someone is willing to pay for it. Many small business owners grow attached to their businesses, and often value their companies at higher levels than industry conventions would dictate. So, it is worth being realistic about the true value of your company before offering it up for sale.

Reason for Sale also plays an important role in business valuation. If a sale is forced, any valuation methods are bound to be discounted to encourage a quick sale.

Our Sincere advice – You should always consult an accountant, or financial adviser, for right business valuation.

[Go Back]