Business valuation is the process of determining or calculating the current value of a company. There are several reasons why companies can order for valuation—we shall discuss these reasons later in this post.
Typically, business valuation is used by owners, investors, bankers, creditors, and the IRS—and the outcome of this process can differ depending on why it was done. Moreover, it’s important to understand that accurately determining the value of a business is both a science and art. That means it’s not everybody’s job.
Business valuation is different from business pricing. The process is considered to be intrinsic—it depends on the business’s actual performance. On the other hand, business pricing is a result of demand and supply. This process incorporates different market influences, like the overall prices, investors, and news and rumors.
Methods of business valuation
There are different ways of valuing a business, and we shall discuss the common methods in this section.
Market capitalization is probably the easiest valuation method because it’s done by multiplying the price per share with the total number of outstanding shares. The price per share is usually taken from the secondary market, and it can vary depending on an evaluator’s perspective. Moreover, the total number of outstanding shares is obtained by looking up a company’s public records.
Let’s look at some examples:
- If Company A has 100 million shares trading at $5 per share, then its market capitalization will be $500 million.
- If Company B also has 100 million shares trading for $10 per share, then its market capitalization will be higher—it would turn out to be $1 billion.
This method represents determining value based on a company’s assets and subtracting any liabilities related to those assets. In other words, this method is all about taking what you have and subtracting liabilities to arrive at a business value. Analysts use different techniques for this purpose, like the market approach and income approach. We shall describe these approaches further in this post:
- Market Approach: This is an appraisal technique based on comparing the subject company with similar existing companies whose values are publicly recorded (i.e., traded on public stocks). It helps determine the value of a business by looking at its peer group—and then making adjustments as necessary to account for dissimilarities between businesses (market comparables) or similarities (market grouping). The advantage of using this method is that it uses past data. That said, the disadvantages are that it’s prone to various data issues and may not be applicable in some cases.
- Income Approach: This approach is typically used for companies involved in high-risk ventures with uncertainty around future cash flows—and risk factors like inflation, economic growth, political conditions, etc. This approach has two types—direct capitalization and residual income valuation (or discounted cash flow).
This is an appraisal technique that projects and accounts for future earnings. There are two types of income valuation—direct capitalization and residual income valuation (or discounted cash flow). Let’s look at these approaches:
- Direct Capitalization: The earnings of a business are directly used to determine its value, typically using multiples like the price-to-earnings ratio. Disadvantages of this approach include that it can be difficult to predict future earnings accurately and that companies with high growth potential but limited historical data may not provide reliable results.
- Discounted Cash Flow (DCF): It calculates company value by projecting future cash flows and discounting them back to the present day using a discount rate. Here, the discount rate accounts for the time value of money and estimated risk. This approach has multiple variations, including using free cash flow, discretionary cash flow, and accounting earnings (or net income).
According to Orlando Business Broker, this business valuation method is used to determine how much a particular company should be worth based on its attributes. During this process, evaluators try to determine if there’s an undervalue or overvalue compared to other companies in the market. Typical techniques include:
- Asset-based valuation: The company’s assets and liabilities are taken as given and evaluated according to current market conditions.
- Intrinsic valuation: This calculates what a business is worth by looking at its financial information and determining the amount an investor would be willing to pay for the entire business.
- Market-based valuation: This method compares companies with similar businesses in size, performance, and other metrics. In other words, it compares a company’s price against its earnings or revenue multiples—to determine whether it’s cheap or expensive relative to peers.
It’s primarily based on determining the value of assets to be received in future cash flows—and then discounting them back to the present day. This process is typically used when a company decides whether to buy an asset from another business early on since there’s a risk that the sale will not go through later due to various issues (e.g., buyers getting cold feet). The advantage of this approach is that it’s less sensitive to forecasting errors than the income approach. That said, there are many drawbacks—including an inability to include all possibilities for future events and not taking tax considerations into account.