Understanding the Basics: What is Business Valuation?

Business valuation is the assessing, determining, estimating, and valuing process of all tangible and intangible assets of a firm or company unit. It can be used to resolve disputes, determine buy and sell clauses, quantify estates for tax purposes, corporate restructuring, establishing investment value, convening an appraisal through a partner entry, markup, and even dissolving partnerships. Ultimately, it assist firms determine potential stakeholders in turning around their business, paying for it as a reasonable rate.

There are several bussiness valuation techniques to valuing a business that are generally accepted as appropriate, each with its own merits and best use cases.

1. Asset-Based Valuation.

This is typically the easiest and most widely used approach. What happens is you simply take all of your company’s tangible and intangible assets, add them together, and then subtract your liabilities. Think about it like selling a car. You would get the current market value, add the upgrades, and subtract any outstanding debt on it. For a company, this usually includes everything from cash, accounts receivable, inventory, machines, real estate, and, less commonly but still often valuable considerations, patents or trademarks and brand equity. While this may seem like the easiest way to value a business, there are times this method will understate the businesses value, especially businesses with a high reliance on intellectual property or in the case of service companies where the value is placed more on human capital to generate value for the clients versus physical assets.

2. Valuation Based on the Market.

This method is simply about comparisons. It examines the recent sales of similar businesses in your industry. For example, if you are selling a coffee shop, you would look for the sale prices of similar businesses (in terms of size, location, and profitability) that have sold. This method is typically the most effective when there are an adequate number of similar comparable businesses for the transactions that you are evaluating. Unfortunately, true comparables are rare since no two businesses are identical. Each will have a different personality, different customer bases, and different efficiencies, which makes it difficult to make direct comparisons. It’s like trying to find a copy of your house – right down to the paint chips good luck!

3. Income-Based Valuation.

One of the most advanced and adaptable methods, in particular for business’ with prior earnings and profitability records, is an approach called Income-Based Valuation. The method focuses on the future earning capacity of your business. The underlying assumption is that a business is worth its future earning capacity for its owners – revenues (or income) you can reasonably expect to receive as the value of ownership in the business. There are a couple of popular methods in the Income-Based Valuation category.

a. Discounted Cash Flow (DCF).

The Discounted Cash Flow (DCF) method is essentially evaluating how much money your business can expect to generate over a future period of time, and then “discounting” that future money back to present values. And the reason you have to discount that future money is because a dollar today is worth more today than a dollar tomorrow. It is an assumption based upon the fact that money normally loses value over time, primarily because of inflation, and because of the opportunity cost associated having that money capitalized today. Think about when you’re purchasing, or planning to purchase, rental property. You would determine what rental revenues you could generate the future, then calculate what that future income stream will mean to you today. DCF is an involved process requiring an individual to establish reasonable estimates, or projections, of future revenues and expenses and capital expenditures, while evaluating an appropriate discount rate given the associated risks of those potential future earnings.

b. Capitalization of Earnings (COE) method.

Another approach based on income is the Capitalization of Earnings (COE) method. The COE method is less complex than DCF and is typically easier to apply in the valuation of more stable, mature businesses with an established economic performance. The COE method divides a representative historical earnings figure by a capitalization rate (which is akin to an investor’s required rate of return, which reflects risk and growth opportunities). The capitalization rate is more like calculating how much you would pay today, based on the consistent income stream on an annual basis.

Which Method to Use

When it comes to the various valuation methods, the type of business, industry, stage of development, and the purpose of the valuation typically lead the decision on which valuation technique to employ. For example, in the case of a startup with little or no earnings, the most appropriate valuation possibly is based on assets or comparative sales or market prices (when comparable startups were sold previously). In the case of an established company with a profit history and cash flow, income based methods such as DCF or COE usually tell a more dependable story.