Steps on How to Value a Business & Common Mistakes to Avoid
Determining a company’s fair market value is a challenging job. You can figure out a company’s economic worth by applying a variety of measurements, which is essentially what how value of a business is all about.
Business valuation is simply figuring out how much a company is worth. Every business aims to make money for its owners, and that’s what valuation is all about.
We’ll go over all you need to know about how to value your business, why you should, and how to avoid common pitfalls.
How to Value a Business for Sale
The valuation method used depends on the condition of the business and the purpose of the valuation. The discounted cash-flow method is generally used for healthy companies generating a profit.
1. Discounted Cash Flow
The discounted cash flow method determines the present value of future profits or earnings. The discount rate reflects the potential risk of the business not meeting profit expectations.
A higher discount rate results in a lower value, which reflects a greater risk posed by the business.
There are variations of the discounted cash flow method that use dividends, free cash flow, or other measures instead of earnings.
The discounted cash flow method usually calculates the present value of five years of earnings adjusted for growth and future earnings beyond five years (known as terminal value).
2. Net Asset Value
The net asset value, also known as book value, is the fair market value of the business assets minus total liabilities on its balance sheet.
Investors and lenders will consider net asset value for younger companies with limited financial histories.
Net asset value is also useful as a lower limit for a valuation range, as it only measures a business’s tangible assets.
3. Liquidation Value
Liquidation value is a key metric in valuing a distressed company, reflecting the net worth of its assets in a forced sale scenario.
It begins with determining the fair market value of tangible assets, and then applying discounts to account for distressed sale conditions.
Liabilities are deducted from this discounted value to derive the liquidation value. Factors such as asset age, market conditions, and legal considerations influence the calculation.
Liquidation value helps stakeholders assess the minimum worth of a company’s assets in adverse situations.
4. Market Value
The market value method is a relative method. It compares a company with its peers and within its industry to arrive at a value by using multiples like price-to-earnings ratio (P/E).
For example, one could value the Really Cool Fans Co. by applying an average P/E multiple for appliance stores to the company’s earnings like this:
Value = Price / Earnings Multiple 25 x earnings $120,000 = $3,000,000
The problem with using a relative method is that it incorporates any errors the market makes in valuing comparable companies as well as in the overall direction of prices.
What Affects Business Valuation?
While there are some parts of a business you can value easily, there are always going to be intangible assets.
Beyond stock and fixed assets (like land and machinery), which are tangible and have clear value, you should also look at:
1. The business’s reputation.
2. The value of the business’s customers.
3. The business trademarks.
4. The circumstances surrounding the valuation (like a forced sale rather than a voluntary one).
5. The age of the business (consider startups making a loss that have lots of future potential, versus established profit-making companies).
6. The strength of the team behind the business.
7. What kind of product do you have.
These intangible assets make it fairly difficult to reach an accurate valuation, but there are several techniques you can use to make it easier.
Why You Would Need to Do a Business Valuation
For an owner who may be looking for financing, considering a sale, or updating a financial plan, here are some common reasons for a business valuation.
1. Merger, Acquisition, and Financing Transactions
Valuations are fundamental to negotiations for the sale, purchase, or merger of a business. Valuations are used to benchmark buy-ins and buy-outs for partners and shareholders.
Lenders and creditors often require valuations as a condition for financing. Valuations are also used to establish and update employee stock ownership plans (ESOPs).
2. Tax and Succession Planning
Valuations determine estate and gift tax liabilities and have an important role in retirement planning. Tax and succession valuations follow IRS guidelines.
3. Litigation
Valuations are also often central to divorce proceedings, resolving partnership disputes, and settlements for legal damages.
4. Strategic Planning
The in-depth analysis of a business valuation can help owners better understand the drivers of growth and profit.
What Business Valuation Means to Investors
Valuing a business is a complex process, and there aren’t any shortcuts.
For the average investor, research reports can offer insights into a company’s value. The business valuation process is an in-depth analysis, yet at the same time, it’s only an estimate.
A basic understanding of the valuation methods, however, can help you clarify your investment philosophy and strategy.
A true value investor analyzes stocks independently of the market and looks for gaps between value and price.
They believe that over time, the price will catch up with value. Price investors look for market trends in the demand for a stock using technical analysis, then try to get ahead of those trends.
Efficient-market investors believe the market accurately reflects value. Value and price investors use active management styles, by selecting specific stocks to outperform the market.
Efficient market investors use passive investment styles, such as index funds.
Common Mistakes to Avoid when Valuing a Business
For the average investor, the biggest mistake is confusing pricing with valuation. Pricing considers demand, and valuation doesn’t
1. Don’t Confuse Assets with Value
A company’s value isn’t the same as the value of its total capital assets. When someone wants to buy your business, they aren’t planning on selling your office furniture or computers.
Instead, they want to know how much revenue and profit the company will generate and how much of a salary they can take as CEO.
While total capital assets may play a role in your business valuation, your company’s value is more complex than that.
2. Don’t Forget to Adjust Forecasted Profits
When calculating your expected profits for the upcoming years, you have to adjust those profits for market conditions, customer demand, and simple fluctuations. No business makes the same profit every year.
A solid financial history can help you create a better profit forecast, but you also have to consider expenses, market fluctuations, increased or decreased marketing budgets, and so on.
3. Don’t Forget to Calculate Required Working Capital and Expenses
Building on what we said in the previous paragraph, you have to consider how your expenses will vary from year to year and whether you will have the working capital required to continue operating your business.
You’ll have to forecast they will tie how much of your assets up in non-working capital, such as accounts receivable.
4. Don’t Be Optimistic, and Remember to Calculate Risks
If you want to get a truly accurate business valuation, you can’t be overly optimistic about your forecasted profits and growth.
In addition, you need to calculate potential risks, as they will affect your company’s value.
5. Use Proper Multiples
When valuing the forecasted profits of your business, it is crucial to use the correct number of multiples.
In other words, how many years can you expect your company to stay in business? If it’s 10, and your profit per year is $100,000, your business may have a value of $1 million (that’s a very simplified statement, though).
Every industry will have a different standard, but it also depends on the size of your company, how many years you have been in business, how much working capital you have your forecasted profits, and other factors.
A small, family-owned business may have an expected multiple of 2-10, while more established, giant corporations may have multiples many times that amount.
6. Understand that Valuations Aren’t Set in Stone
Valuations can and do change over time. Just because you got your business valued a year ago, that doesn’t mean the same projected value is valid now.
Since business valuations take so many factors into account, valuations can fluctuate.
Also, remember that your company’s value may be a range between a lower and higher value.
That’s because certain risks are harder to quantify, and the final value may depend on the buyer’s risk tolerance. In addition, the urgency of the sale and your relationship with the buyer can also affect the rate.
7. Don’t Attempt to Do a Valuation Yourself
This mistake is common. There are so many variables you need to consider and so much data to look at that doing a valuation yourself often leads to trouble.
In addition, there is more than one valuation method, and it is vital to use the right one for your industry and business size. One common pitfall is mixing valuation methods and ending up with inaccurate results.
Pros of Using a Business Valuation Calculator
Using a business valuation calculator is a fast and simple way to get a ballpark value of a business without hiring an expert and with minimal effort; however, it’s not without its disadvantages.
Some of the pros of using a business valuation calculator are:
1. A business valuation calculator can be used as a quick and easy tool to ballpark a business’s value, which can be especially useful when comparing many businesses to each other.
2. Most business valuation calculators include an average industry multiple in the calculation, which is useful as not all industries have the same risks and opportunities.
3. The valuation calculator is based on a business’s bottom line, which is how much money a business generates notwithstanding assets and liabilities.
Cons of Using a Business Valuation Calculator
Some of the cons of using a business valuation calculator are:
1. The valuation calculator excludes tangible and intangible assets, which can make up a significant portion of the actual value of a business in asset-heavy industries.
2. For some businesses, bullish market trends may indicate a much stronger valuation. Conversely, for businesses operating in a contracting market, this approach may over-inflate the value of the business’s future revenues.
3. The biggest flaw in any math-based valuation method is the absence of expert analysis.
After you’ve figured out what your business is worth, you might decide it’s time to sell or bring in investors.
Besides the value, there are other things you need to decide, like the terms of the deal, any restrictions, and when it’s all going to happen.