How can you determine what a business is worth? Experts use different business valuation methods to help business owners ask for a reasonable price when selling their business or proving their net worth. Here are seven methods you can use to assess the value of a business.
How much is your business worth? There are different methods used to determine how much a business is worth. Business valuation is something you should look into if you are looking for investors, business partners, or want to sell your business. Here are the different business valuation methods you should think about using.
How We Selected Business Valuation Methods
We tried to include several methods used by professionals. Here is how we selected the methods presented below:
Top Seven Best Business Valuation Methods
These are the different business valuation methods you should be familiar with as a business owner. Keep in mind that each method has a slightly different purpose, and don’t hesitate to use more than one method to get a more accurate idea of what your business is worth.
1. Market Capitalization
This approach gives you an idea of the size and value of a company. The downside is that you need to look at data associated with the shares the company issues.
Since not all businesses issue shares, market capitalization can’t be used to assess the value of every company.
You can calculate the market cap of a company by multiplying the cost of a share by the number of shares outstanding. This method allows you to compare market caps between similar businesses in the same sector to make good investing decisions.
2. Enterprise Value
The market capitalization method is useful if you want to get an idea of the size and value of a business. However, this method leaves out some important information regarding liabilities that can impact the value of a business.
The enterprise value method is more accurate since it takes this information into consideration. You can calculate the enterprise value of a business by calculating the market cap and subtracting the total debt of the business. You can also add the cash on hand for a more accurate result.
This method is interesting because it factors in long-term debt that will eventually boost the value of the company.
3. Earnings Or Profit Multiplier
This method is about showing a business’ ability to generate profits. It is an interesting metric to look at in the context of selling a business.
Use this valuation method to calculate the profit the business could generate over the next year. However, you need to figure out what kind of profits a new owner could generate.
The expenses you incurred as an owner, such as your business loan payments won’t be taken into consideration. You will need to add any relevant expenses that a new owner would encounter, such as relocating the business.
There are standard multipliers for each industry. For instance, the food service industry typically multiplies earnings by two. If you were to sell a food service business, you would multiply expected yearly profits by two to give a potential buyer an idea of the value of the business.
4. Times Revenue Method
The times revenue method is about calculating the maximum value of a business. This metric will give you an idea of how much profits a business could generate if sales are optimal.
You can use the current profits of the business and apply a multiplier that reflects optimal growth for the business. Ideally, the multiplier you use should be based on how similar businesses in your industry have been performing.
The times revenue method is particularly relevant in the context of franchises. You can use multipliers that reflect how other locations of the franchise have been performing to assess the kind of profits that can be expected from another location of this same franchise.
You can use a range of multipliers to reflect different scenarios. Make sure you adjust the multipliers you use in function of current industry trends and how the business has been performing.
5. Discounted Cash Flow Method
The purpose of this valuation method is to compare investing in a business with another potential investment. The discounted cash flow method will help you figure out how to pay a fair price for a business.
You need to choose a time range to compare the cash flow of a company with another investment. Determine the growth rate of the other potential investment, and use it to determine what the estimated future cash flow of the company would be worth to you today.
Let’s say you can spend $10,000 on a business venture or invest this money in a portfolio that grows at a yearly rate of five percent. You can expect to generate a cash flow of $6,500 on the third year of operating this business. Compared to the growth rate of the portfolio, $6,500 is worth $6,310 to you at the moment.
The business wouldn’t be a good investment within this timeframe. However, the business might turn out to be a better investment than the portfolio with the five percent return depending on the future estimated cash flow past the three-year mark.
6. Book Value Or Net Asset Value
This method calculates the equity you own in your business. You can calculate the book value of a business by adding the total value of the assets and subtracting any existing liabilities.
You can look at the book value and the price-to-book ratio to get an idea of how efficient a business is. These metrics will typically reflect the business’ ability to extract value from liabilities such as a business loan.
You can also calculate the fair market value of the assets. This valuation method would reflect what it would cost to purchase these assets today minus the liabilities incurred by the business.
You should adjust the outcome to reflect the value of intangible assets such as intellectual property or customer loyalty.
7. Liquidation Value
The liquidation value method is about figuring out what you would get if you were to sell the tangible assets of a business. This is a realistic approach if you are looking into filing for bankruptcy.
You should use the liquidation value method if there is no cash flow that can be expected in the future. Note that this method is different from the book value or net asset value method since it looks at how much you can get for the assets if you were to sell them right away.
You might also have to figure out the salvage value of some assets that will be scrapped rather than sold.
How To Choose The Right Valuation Method
The most relevant business valuation method depends on why you need to assess the value of a business. It also depends on what kind of future the business has.
There are different scenarios in which you would need to assess the value of a business. You might want to buy or sell an existing business.
You might need to assess the value of your business because you need to list your assets on a financial statement or share information about your net worth.
You might also need to figure out how much a business is worth so you can split it between partners, or share information with potential investors. There are other scenarios in which you would need to determine the fair value of a company, such as comparing businesses to invest in stocks or filing for bankruptcy.
Ideally, you would use more than one valuation method to get a more accurate idea of how much a business is worth regardless of the scenario you are in.
If you are interested in buying, selling, or investing in a business, your focus should be on future earnings. Current assets are interesting, but the potential and the value of the business reside in future earnings.
Use different valuation methods to look at the business’ ability to generate profits, how quickly future earnings are likely to grow, and how well the business has been turning liabilities into profits in the past.
There are different options available if you need to share information about your assets and net worth. You could figure out the book value of the business and adjust it to reflect intangible assets, or reduce the book value if assets have been depreciated and the business is not performing well.
If you are comparing businesses to figure out which stocks you want to invest in, use a combination of market cap and book value. Focus on ratios that reflect the health of the company, and compare these ratios with other businesses in the same industry.
How Does The Business Operate?
Some business valuation methods are more relevant than others if your business has significant operating costs. The stage your business is in will also impact the best valuation method.
You should assess how the business operates and what its future needs will be. Many valuation methods reflect a business’ potential for generating profits in the future. Sometimes this can’t happen unless significant expenses are incurred, such as investing in new equipment or relocating the business.
Risks should also be taken into consideration. It is best to create a range of valuations to reflect different scenarios, especially if your business is in its early stages. If you are looking for financing, you could create different valuations depending on how much money you can borrow or secure from investors.
The Future Of Your Business
It is important to be realistic about the future of your business when using a valuation method. Using a method that focuses on future profits makes sense if your business has a solid track record and if you have plans for growth.
If the future of the business is uncertain or if you are considering bankruptcy, you should focus on the tangible assets of the business.
A business valuation method that focuses on the fair value of the assets can also give potential buyers a more concrete idea of what they are investing in. You should combine it with other methods that reflect the business’ potential for generating profits.
Adjust The Value
Business valuation isn’t an exact science. The different methods listed above will give you an idea of what a business is worth, but the actual profits you generate in the future will probably slightly differ from the valuation.
You need to adjust the value you obtain after using any of these methods. Ideally, you should explain why you adjusted the value of the business and provide supporting evidence.
Intangible assets aren’t used in the business valuation methods listed above. The patents associated with your business can significantly improve its value. There are other things that can impact the value of a business, such as loyalty, online outreach, or brand image.
You can also increase the value of a business to reflect the time and efforts you have put into organizing the workflows and creating a business that runs smoothly. If you are struggling with organization or administration, don’t hesitate to decrease the value of the business to reflect this.
The industry you are in can also impact value. If experts believe your industry is going to keep growing at a fast pace due to high demand, this justifies increasing the value of your business. However, a business in a struggling industry that is threatened by online competitors would likely lose some of its value in the near future.
These different valuation methods should help you get an idea of how much a business is worth. Remember to select the method that makes the most sense for your situation and to combine different methods to get a more accurate idea of what a business is worth.