Business valuation is how to convert a company’s story, history, brand, products, and markets into dollars and cents. Valuation is used by investors, business owners, bankers, and creditors, as well as the tax authorities, and the process can yield varied results depending on the objective. Accurately calculating value is, in fact, both an art and a science.
What is Business Valuation?
Business valuation can be described as the process or result of determining the economic value of a company. All businesses have one thing in common: the goal is to generate profits for shareholders. The time frames, methods, and assumptions may differ, but the goal remains the same.
Ultimately, the value of any business depends on the present value of future expected profits. The valuation process deeply examines the company’s operations, expenses, revenues, strategy, and risks to arrive at assumptions regarding future profits, time frames, discount rates, and growth rates.
All business valuations are estimates. The objective of the valuation and who conducts the analysis greatly influence the final outcome. Investment bankers want to value a company for an initial public offering at the highest possible number, while accountants aiming for tax purposes seek the lowest possible number.
Valuation is different from pricing. Valuation is intrinsic; it is based on the actual performance of the business. Pricing is based on supply and demand; it incorporates market effects such as overall price trends, other investors, and new information such as rumors and news.
Why Do You Need a Business Valuation?
For an owner who may be looking for financing, considering selling, or updating a financial plan, here are some common reasons for a business valuation.
Mergers and Acquisitions and Financing Transactions
Valuations are essential in negotiations for selling, buying, or merging a company. Valuations are used to establish a baseline value for partners and shareholders. Lenders and creditors often require valuations as a condition for financing. Valuations are also used to create and update employee stock ownership plans (ESOPs).
Tax Planning and Legal Disputes
Valuations determine estate and gift tax obligations and play an important role in retirement planning. Tax valuations and subsequent disputes follow guidelines issued by the Internal Revenue Service (IRS).
Strategic Planning
A deep analysis of business valuation can help business owners gain a better understanding of growth and profit factors.
Business Valuation Methods
The method used for valuation depends on the state of the business and the purpose of the valuation. The discounted cash flow method is commonly used for healthy businesses that generate profits.
Discounted Cash Flow
The discounted cash flow method determines the present value of future profits or earnings. The discount rate reflects the potential risk that the business will not meet profit expectations. A higher discount rate leads to a lower value, indicating greater risks faced by the business. There are variations to the discounted cash flow method that use dividends, free cash flow, or other metrics instead of earnings. The discounted cash flow method typically calculates the present value of five years of adjusted earnings growth and future earnings beyond five years (the terminal value known as the terminal value).
Net Assets or Book Value
Book value or net asset value is the fair value of the business’s assets minus total liabilities on the balance sheet. Investors and lenders often consider the book value for younger companies with limited financial history. Book value is also useful as a minimum range for valuation, as it measures only the tangible assets of the business.
Liquidation Value
Liquidation value is the book value of assets reduced for forced sale. Investors and lenders may consider liquidation value for younger companies or companies at risk of struggling.
Market Value
The market value method is a relative method. The company is compared with its peers and within its industry to arrive at a value using multiples such as the price-to-earnings (P/E) ratio. For example, one could value Really Cool Fans Co. by applying the average P/E multiple for hardware stores to the company’s earnings like this:
Value
= Price / Earnings Multiple 25 × Earnings 120,000 = $3,000,000
The problem with using relative methods is that they incorporate any errors made by the market in evaluating comparable companies as well as the overall trend in prices.
What Does Business Valuation Mean for Investors?
Business valuation is a complex process, and there are no shortcuts. For the average investor, research reports can provide insight into a company’s value. The business valuation process is a deep analysis, and at the same time, it is merely an estimate.
However, a basic understanding of valuation methods can help clarify your investment philosophy and strategy.
Investors analyze the true value of stocks independently of the market, looking for gaps between value and price. They believe that price will catch up to value over time. Investors look for market trends in demand for stocks using technical analysis, and then they try to outperform those trends.
Investors in efficient markets believe that the market accurately reflects value. Value investors and price investors employ active management styles, focusing on specific stocks with the aim of outperforming the market. Investors in efficient markets use passive investment styles, such as index funds.
Frequently Asked Questions (FAQs)
Is the history of business valuation important?
Yes, valuations must be completed for financial reporting and tax purposes by a deadline. Valuations for mergers, acquisitions, financing, and other transactions must meet the needs of stakeholders.
What are the elements of business valuation?
Business valuation can be considered in terms of “why,” “how,” and “who.” Why is the goal of the valuation. Valuations conducted for different purposes may yield different results. How the valuation method is chosen. Different methods may produce different outcomes. Who is the individual or company conducting the valuation. Their experience and philosophy affect the results.
What are common mistakes in business valuation?
For the average investor, the biggest mistake is confusing pricing with valuation. Pricing considers demand, while valuation does not. Both pricing and valuation are used to make investment decisions, but they are different.
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy and reliability of our content.
Internal Revenue Service (IRS). “IRS Revenue Ruling 59-60.”
Patrick L. Anderson, Ilhan K. Geckil, and Nicole Funari. “The Three Essential Factors in Estimating Business Value or Commercial Damages.” AEG Working Paper 2007-1.
National Association of Certified Valuators and Analysts. “Chapter Six – Commonly Used Methods of Valuation.” Page 7.
National Association of Certified Valuators and Analysts. “Chapter Six – Commonly Used Methods of Valuation.” Page 13.
Source: https://www.thebalancemoney.com/business-valuation-methods-2948478
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