Your company is an important asset. Learning its true value is necessary as you prepare for a Merger and Acquisition process (M&A). Evaluating a business is science that demands the application of smart valuation methods. However, keep in mind that buyers and sellers alike use different business valuation methods to assess companies. So several buyers may present different offers for your business than you’d expect.
Understanding how buyers arrived at their conclusions is important. But, there are no fixed formulas or rules for evaluating a business. The value of your company is going to be based on what you want to sell it for and the offers received from potential buyers.
We’re going to briefly go over the top business valuation methods you can use to uncover your organization’s value. You’ll most likely need to consult with a certified business appraiser to apply them since some involve complex mathematics. Here are some top business valuation methods used by experts.
1. Asset Valuation
Asset valuation ignores the profit-generating aspects of a business and focuses on the net value of company assets. This includes tangible assets like equipment and intangible assets such as brand name. Make sure you exclude all liabilities from your calculation (e.g. leases, borrowed equipment, etc.). Also, you may have to deduct depreciation from the book value of assets.
Here’s a simple example. A computer bought ten years ago with a book value of $1000 would be worth zero today. Assuming it depreciates at a rate of $100 per year. Overall, the process of calculating depreciation can become quite complex quickly. So hiring a qualified company valuator or CPA is recommended. Furthermore, the asset valuation method may be ideal if your business has lots of assets or its revenue-generating capabilities are limited.
2. Earnings Capitalization Valuation
The primary concern for many investors is ROI, however, that’s relative to the market. The earnings capitalization valuation method uses current earnings to predict future profit performance. To use this method, first, calculate the NPV (Net Present Value) or the future stream of cash flow (net income). This can be the average net earnings of the business over a period of years.
Then calculate the cap rate or expected rate of return (e.g. 20 percent). Divide NPV by cap rate to get the business value. The most recent earnings of the company will be weighted more heavily than past earnings. Ultimately, the goal of the investor is to assess potential returns against the risk of purchasing your business. This method will help them anticipate the worth of future profits.
3. Historical Earning Valuation
Here, the value of a business depends on cash flow capitalization and debt elimination. So value drops whenever cash flow is low and debt is high. Use these factors to determine your business’s value. Think of the historical earnings valuation method as an analysis of company income vs. debt for a period of time. Take at least three to five years worth of your company’s financial information. Specifically, use the information on your balance sheets and income statements for several tax years to calculate the value.
4. Earnings Multiple Valuation
Investors use the earnings multiplier method to get a more accurate picture of a business’s value. This method focuses on profits instead of revenue since it’s a more reliable indicator of financial success. The company value is calculated by multiplying its adjusted profits with a multiplier based on the amount being invested.
The earnings multiple chosen will be based on the risk attached to the business’s future earnings. A higher multiple is used when risk is low. A lower multiple is used when considered risk is high. In addition, future earnings are reflected in the chosen multiple. A high earnings multiple is used if projected revenue growth is high. Low multiple is used when expected earnings growth is low.
5. Discounted Cash Flow Valuation
DCF (Discounted Cash Flow) can provide an accurate assessment of probable future business earnings. DCF estimates the value of your company based on the future or projected cash flow. This is a good method to use because sometimes the business will be worth more than you think. Also, this business valuation method may be useful if you suspect that future earnings won’t remain the same.
6. Future Maintainable Earnings Valuation (FME)
FME is a simplified version of DCF. Consider using FME if profits are expected to remain the same in the foreseeable future. This method evaluates profits, expenses, and revenue for the past three years to determine the company’s current value. Also, worth noting is that this business valuation method separates any surplus.
7. Relative or Comparable Valuation
This model compares the company’s financial value against other similar companies. Comparisons are made based on comparable business assets on the market to determine a reasonable price for your company. This valuation method is often used in real estate investments.
For example, let’s assume you wanted to buy a new home in Atlanta, Georgia. The owner is asking for $500,000. In this case, you’ll need to find several comparable homes in Atlanta and average out their asking price. Then tweak the owner’s asking price further based on things like liabilities, existing damages, and so on. While this is a very simple example, the same process applies for finding your business’s value.
8. Book Value Method
The book value method is really simple. This takes the value of shareholder’s equity as specified in your company’s balance sheet and subtracts liabilities. In other words, it subtracts all expenses (e.g. debt, rental, etc.) from the business’s total assets.
9. Liquidation Value
This business valuation method calculates how much a company is worth after assets are liquidated to pay off liabilities. The resulting net cash becomes the company’s true value.
Make The Necessary Considerations
The aforementioned business valuation methods are useful but carefully consider any potential drawbacks. Ideally, you should use a method that plays to your company’s strengths, not its weaknesses. So make sure you’re carefully considering the business’s current condition. Lastly, remember that the value of your company ultimately depends on what buyers are willing to pay for it.