Before buying or selling a company, one necessity is to conduct a valuation. This is where you evaluate the economic value of a company and determine its worth. However, valuing a company can be hard. It demands a certain set of skills.
In this article, we explore how to value a company and the steps involved in company valuation.
What Is A Business Valuation?
A business valuation entails calculating the economic value of a company. Businesses use it to determine the fair value of a business for a variety of reasons. For example, investors and buyers interested in a company use the valuation to make an informed economic decision.
The valuation can include analyzing the capital structure of your business and the market value of its assets. You can also look towards the profits, revenues, and losses when conducting a business valuation. The aim is to determine the intrinsic value of the company. An effective business valuation helps investors and entrepreneurs make informed decisions on investment and purchase.
Business Valuation Process
The business valuation process is a series of steps that you must follow in a certain order. It involves a significant amount of skill. For example, you must work around estimates and assumptions since the financial model depends on subjective inputs.
There are different tools to use during the business valuation process. The tools vary depending on the evaluator, the business, and the industry. Some businesses use a review of financial statements, while others perform company comparisons.
Market capitalization is one of the many ways you can perform a business valuation. It entails multiplying the company’s share price by the total number of shares outstanding. You can also use an earnings multiplier to value a company. This method provides an accurate picture of the real company value using its profits.
The market value approach is another important way of valuing your business’s worth. It involves comparing your business with similar ones on the market. For example, use comparables to value a house if there are bigger businesses in the same industry.
Discounting future earnings is another earning value method. This is where you project the cash flow of a company for the next five years. You calculate the terminal value of the company beyond the forecasted period of earnings. Start by estimating cash flows and the terminal value, then discount the values using an appropriate rate for the company.
Since a business’ value depends on its ability to produce wealth, you can determine an expected income level using the record of past earnings.
Asset-based business valuation entails looking at the balance sheet and subtracting the total assets from total liabilities. You can also use the asset-based approach to value a business. For example, if a company has $1000 assets and $300 liabilities, its value would be $700. You can also use a liquidation approach. It entails taking the business assets and determining the revenue if you sold everything.
The general rule of thumb is using multiple methods to perform a business valuation. Using over three methods can provide an accurate estimate of a business value. Therefore, look for an average from three or four methods rather than using one method.
Types of Business Valuation
You can conduct a discounted free cash flow method or a comparable transactions method. The comparable method is a quick and reliable method of estimating the value using multiple comparable companies.
The discounted free cash flow method focuses on estimating the company’s ability to generate wealth. It entails analyzing past data to provide an insight into factors that might affect future financial projections. Here, you calculate the value of expected future cash flows using discounted cash flow analysis.
The type of business valuation depends on the industry sector, company size, and expected cash flow.
Importance of Conducting a Company Valuation
Business owners are likely to underestimate the importance of business valuation. However, this important process can have future financial implications. The valuation helps in calculating the asset’s intrinsic value that is different from the trading market price. A company’s intrinsic value is objective and isn’t affected by short-term economic fluctuations.
Several groups are interested in the value of your company. Investment bankers use the valuation to provide effective advice for investment. Entrepreneurs also use the valuation data to get a fair price for their shares.
You must know a business’ value before investing in it. The valuation can help you avoid overspending or underselling a company. The valuation is crucial for pitching to investors. Knowing the value of a company helps investors during negotiations.
What to Consider Before Business Valuation
Several factors come into place when conducting a valuation process. You must have the financial records to facilitate a business valuation. They include revenues, costs, and debts that help in calculating the growth rate. If a business has higher growth prospects, it will receive a high valuation.
Also, look at the profitability or risk of conducting a business valuation. Investors are likely to consider the opportunity cost of buying your business. If your assets are more profitable with fewer risks, an investor will invest them. Marketing conditions, such as interest rate levels and the state of the economy, are other important factors to consider. A company will have a higher valuation in a booming economy.
Before valuing a business, provide accurate information about the business operations and finances. Sometimes you have to consider the salaries and wages of employees when valuing a business.
Bottom Line
The value of a company differs from its price. When talking about valuing a startup, you refer to determining the business’s worth before buying or selling. Business valuation is crucial when planning to sell a company. It provides an insight into the critical areas of your business while providing an accurate estimation of the value range.
Work with a professional business evaluator to help you get an aim estimate of the value of your business. The expert will advise on the best method to use when planning to sell a business.