5 Common Business Valuation Methods
Business Valuation: 5 Common Methods
Business valuation is necessary for starting, growing, or exiting a business. Learn about the five most common methods for valuing a business, including asset, historical earnings, and future maintainable earnings valuation.
The asset valuation method determines the value of tangible and intangible assets. Tangible assets are easily identified and valued, while intangible assets are difficult to identify and value. Tangibly defined items include cash, inventory, equipment, property, other resources, etc. In contrast, intangibly specified items include:
- Goodwill (e.g., reputation).
- Patents/trademarks/copyrights (e.g., product design).
- Customer relationships (e.g., long-term customers).
Historical Earnings Valuation
This method is the most straightforward. You determine the historical earnings of the business and multiply it by a multiple to arrive at its current value. For example, your client’s company has generated an average annual net income of $10 million over the last five years (2010-2014). You then determine that similar businesses have historically sold between 6x and 10x their annual earnings, so you apply an 8x multiple to arrive at an estimated value for your client: $80 million. 8x ($80mm) = $640mm or approximately $640 million.
You can also use relative valuation to value your business. This method involves comparing your company to similar businesses and asking how much the other companies are worth.
For example, if you have a restaurant, it makes sense to look up what other restaurants are selling for and then compare those valuations to yours. Alternatively, you may find that there haven’t been any recent sales of restaurants like yours—in which case, you might want to look at companies in another industry that offer similar products or services (and their valuations).
When using this type of valuation, the most important thing is to make sure you’re comparing apples to apples. If two businesses sell burritos, but one sells them on a street corner while another sells them online, they’re not comparable!
Future Maintainable Earnings Valuation
First, future maintainable earnings valuation determines a company’s ability to earn profits in the future. The process involves calculating net income and net cash flow, projecting the future cash flow, then discounting (or reducing) it to present value. In other words, it’s an assessment of how much you can expect to make if you own this business over time—and how much it would be worth if you bought or sold that same business today.
To calculate net income and cash flow for your business, look at your balance sheet and calculate any adjustments for depreciation expense and owner’s compensation/drawings from equity accounts.* Then subtract all operating costs except the cost of goods sold (COGS) from total revenue.*
- Cost accounting methods vary by industry but typically include labor costs; materials used; depreciation on assets such as machinery; maintenance expenses; taxes paid; interest paid on loans used for operation capitalization (e.g., machinery); insurance premiums paid; advertising costs incurred; utilities consumed during production periods (electricity); etcetera.*Next divide by the expected number of years left until end-of-project life date when COGS will no longer be applicable due its limited lifespan within this industry sector.*Finally multiply whole numbers above together until they equal 100%.
Discount Cash Flow Valuation
Discounted cash flow valuation is the most common method of determining the value of a business. The formula for discounted cash flow valuation is as follows:
N = (1 + r)^n – 1/r
where N = Net Present Value of all future cash flows, in present value terms.
r = Discount rate (the rate at which money today is worth). That can be the rate at which you expect to receive cash from your investment, or it can be an average of other similar investments with similar risks and returns.
n = Number of years over which you are projecting your cash flow (the life span of your business).
How much your business is worth depends on the method you use.
The value of your business depends on the method you use. There are several different ways to evaluate a company, each with its strengths and weaknesses. You might choose one method or multiple methods to determine what your business is worth. You could also decide not to do any business valuation since there’s no real way to know what will happen in the future.
The five most common methods are:
- Comparable companies analysis – This compares your company’s revenue with similar companies’ revenues to get an idea of how much yours should be worth. It also looks at other factors like profit margins and growth rate. While this is useful for a general understanding of trends, it doesn’t consider factors specific to your industry, like market demand for products or services offered by competitors (which could make them more attractive).
- Discounted cash flow model – This method estimates the present value (that is, how much money would have been made if invested today) by looking at future cash flows from operations along with expected costs incurred during those periods (such as depreciation). Each year’s projected cash flow minus its estimated cost must add up.
Hopefully, you now feel more comfortable with the different business valuation methods. If you have questions about which method is best for your situation or need help deciding which plan is right for your business, don’t hesitate to contact us!