Business Valuation: Meaning, understanding And How Investors do Business Valuation?

A business valuation is how the story of a company, its history, brand, products, and markets, is translated into dollars and cents. Valuations are used by investors, owners, bankers, and creditors, as well as the IRS, and the process can have very different results depending on the objective. Accurately calculating value is both an art and a science.

What is Valuation?

Valuation refers to the process of determining the present value of a company or an asset. It can be done using a number of techniques. Analysts who want to place value on a company normally look at the management of the business, the prospective future earnings, the market value of the company’s assets, and its capital structure composition.

Valuation may also be used in determining a security’s fair value, which depends on the amount that a buyer is ready to pay a seller, with the assumption that both parties will enter the transaction.

During the trade of a security on an exchange, sellers and buyers will dictate the market value of a bond or stock. However, intrinsic value is a concept that refers to a security’s perceived value on the basis of future earnings or other attributes of the entity that are not related to a security’s market value. Therefore, the work of analysts when doing valuation is to know if an asset or a company is undervalued or overvalued by the market.

Valuations can be performed on assets or on liabilities such as company bonds. They are required for a number of reasons including merger and acquisition transactions, capital budgeting, investment analysis, litigation, and financial reporting.

Table of Content 

• What is Business Valuation?

• Understandings Of Business Valuation/

• Different Types of Approach for Business Valuation?

• Methods For Business Valuation?

The Basics of Business Valuation

The topic of business valuation is frequently discussed in corporate finance. Business valuation is typically conducted when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business.

A business valuation might include an analysis of the company's management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include a review of financial statements, discounting cash flow models and similar company comparisons.

Valuation is also important for tax reporting. The Internal Revenue Service (IRS) requires that a business is valued based on its fair market value. Some tax-related events such as sale, purchase or gifting of shares of a company will be taxed depending on valuation.

Three approaches to a business valuation

When your company is ready to go through a business valuation, there are three major approaches. Each one has its own benefits to consider, so it’s wise to evaluate which is best for you and your business.

• Asset-based approaches

An asset-based approach totals up all of the investments in the company to determine the value of the business. When you choose an asset-based approach, all of your investments will be totaled up in one of two ways....

• A going concern asset-based approach, also known as book value, will review your company’s balance sheet, list the business’ total assets and subtract its total liabilities.

• A liquidation asset-based approach is used when determining the liquidation value or net cash value of your business if all your assets were sold and liabilities paid off. This is a common approach for business owners who are looking to sell their business or get out from under it.

Asset-based approaches work well for corporations, as all assets are owned by the company and are included in the sale of the business. For sole proprietorships, however, this approach can be a more difficult means of evaluation. If any assets belong to or are in the name of the sole proprietor, separating the value of business assets from their personal assets. For example, if a sole proprietor is ready to sell an IT company, prospective buyers of the business would have to take the time to sort through which assets belong to the business and which ones stay with the sole proprietor. 

• Earning value approaches

The earning value approach evaluates businesses based on their ability to produce wealth in the future. This approach is generally used for a company that is looking to buy or merge with another company. There are two types of earning value approaches.....

• Capitalizing past earnings: This method reports the company’s usage of past earnings, normalizes them, then multiplies the expected normalized cash flows by a capitalization factor. This rate is what a reasonable purchaser would expect on their investment of the business.

• Discounted future earnings: This approach averages the trend of predicted future earnings for the company, then divides it by the same capitalization factor.

• Market value approaches

When assessing the market value of their business, owners establish what the business is worth based on similar businesses that have recently been sold. This sometimes leads to a business being under- or overvalued.

If your business and its assets are worth about $5 million but similar companies have been sold in the $2-million range, you may lose money on the sale. Earning value approaches are the most popular means of business valuations, but that doesn’t mean it’s the right choice for you. In fact, a combination of these three methods may be the best way to get a fair and accurate value for your company. The best way to get the fairest valuation is to hire an experienced business valuator to advise you on the best methods of how to evaluate your business.

Methods of Valuation

There are numerous ways a company can be valued. You'll learn about several of these methods below.

• 1. Market Capitalization

Market capitalization is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of shares outstanding. For example, as of January 3, 2018, Microsoft Inc. traded at $86.35.2 With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.

• 2. Times Revenue Method

Under the times revenue business valuation method, a stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.

• 3. Earnings Multiplier

Instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current P/E ratio to account for current interest rates.

• 4. Discounted Cash Flow (DCF) Method

The DCF method of business valuation is similar to the earnings multiplier. This method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The main difference between the discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value.

• 5. Book Value

This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets.

• 6. Liquidation Value

Liquidation value is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today.

This is by no means an exhaustive list of the business valuation methods in use today. Other methods include replacement value, breakup value, asset-based valuation and still many more.