When it comes to business valuations, there are many different formulas professionals use to determine the value of your company. Some are more intuitive than others, but they all have one thing in common – they're based on past examples.
By understanding how other companies achieved success, you can develop your own valuation formula that includes these components.
In this article, we'll go over the basics of two of the most popular formulae for business valuations - the market approach and the dividend discounting (or discounted cash flow) method.
We'll also take some time to compare both methods by looking at a few example companies and determining which one is better!
Keep reading to learn more about these important tools for business owners.
The appraisal method for business valuation is typically categorized as either market-based or income-based approaches. Both have their benefits and drawbacks, but most experts agree that the best way to value a company is by taking a combination of both concepts.
Market approaches look at how much other companies are paying for similar assets in order to determine an asking price. While this can be tricky because not every buyer wants to divulge such information, you will get close estimates depending on what comparable sales exist.
Income approaches calculate a firm’s net profit over a specific time frame to see what an appropriate selling price should be. This removes any influence of non-operational costs like depreciation which many sellers choose to exclude when buying a business.
When using both theories together, it is important to note that neither one dominates the field. Each has its own set of strengths that must be considered along with personal preferences to make a more accurate assessment.
The financial approach to business valuation is focused on estimating the value of your company by looking at its underlying assets, including equipment, property, and good will. These asset values are then applied to different formulas that calculate the market or “fair” price for the company.
The most common formula used is the income-based capitalization (IBC) method which calculates the price per share based on an estimate of how much money a shareholder could earn if the company were sold and their shares remained the same. This income is projected forward in time so it includes profit forecasts as well as interest rates assumed for the loan.
Importantly, when calculating net income, adequate allowances must be made for taxes! While companies typically account for tax payments in their internal finance documents, there are several standardized methods for incorporating this into a business appraisal. Certain rules apply depending on the type of business, but all too often owners fail to include these in their calculations.
It is very important to remember that no matter what methodology you choose, you should assume both favorable and unfavorable scenarios for the company. Calculating only positive projections removes the incentive for shareholders to keep investing in the company and potentially even incentivizes them to push out current leadership to ensure a smooth sale.
On the other hand, assuming extremely pessimistic numbers for the future growth or decline of the company can skew results significantly. It also makes it difficult to compare apples to oranges since one party may use more realistic assumptions than another.
The comparable sale method is one of several business valuation techniques that deal with determining the fair market value or “price” to assign to a company. This price typically is determined by finding similar businesses in the marketplace and then using those prices as a reference for the current state of the company.
A recent example of this comes from our latest article, where we discussed how to determine the fair market value of a restaurant business. In that case study, we used two different approaches depending on whether the buyer was looking at the business as an investment property or if they wanted to retain their own brand name.
When it comes to valuing a business, there are three main methods: income-based, asset-based, and comparative sales. While each one has its strengths, most experts agree that the comparative sales approach is the best way to go when estimating the value of a business.
Why? Because it requires no preliminary assumptions about the future performance of the business. What you need to find are companies in your market that have been sold recently and for a good amount of money!
By studying past transactions, what makes a successful sale is often learned. An investor might learn something like why the seller was able to get such a great return on his or her investment. Or perhaps what type of marketing strategies worked well for the sellers’ competition. These things can be applied to help improve the marketability of the business being studied.
The income approach to business valuation is focused on determining the value of a company determined by its market or intrinsic value. This includes looking at what market competitors are paying for companies, how much money they are earning, and extrapolating that into what the firm is worth.
The most common way to apply this method is to compare the price with per-share earnings. By doing so, you can determine whether the stock price is low or if shareholders are paying too little for the company.
A quick note about per share earnings — in general, the higher the number the more valuable the company and it’s shares. A lot of things can affect per share numbers such as dividend payments and apportioning expenses across different divisions, but overall, higher earnings mean a high quality company with strong fundamentals.
Another important concept when applying the income approach to business valuations is to understand the going rate assumption. The going rate assumption assumes that current buyers are bidding their own personal wealth to purchase a company.
This assumption varies from buyer to seller and depends on many factors. However, one thing is certain, people will always pay more for something than what they would be willing to take away from it.
The asset approach to business valuation is one of the most popular approaches in business valuations. This approach looks at the value of a company determined by its assets, including equipment, furniture, computer systems, loans, etc. A significant portion of the cost for most companies is due to their depreciation, or the reduction in value as they are spent.
The overall depreciation can be calculated using an appropriate lifespan and annual use for each item. Then, those costs can be added up to determine the depreciated value of all items. From there, the net profit can be found by subtracting the depreciated value from the purchase price. Finally, the average sales price of similar businesses can be used to calculate the market value of the company.
The market approach to business valuation is one that focuses on what market transactions indicate the company’s value should be. Because companies with higher values are able to generate more money through their stock offerings or product sales, they assume that shareholders also want to invest in stocks of similar companies.
By analyzing recent corporate acquisitions, dividend payouts and capitalization rates, we can determine an appropriate price target for the company being valued.
The capitalization rate is determined by taking the average cost per share of all outstanding shares and dividing it by the average net profit per share over a specific period.
We can then use this price as our benchmark to calculate the fair value of the firm.
Market approaches to business valuations have become increasingly popular due to its accuracy. By using information gathered from corporations actively looking to buy out other businesses, these analyses provide very thorough insights into how much a company is worth.
Using this method alone, you can get a pretty solid picture of where your company lies in terms of value.
However, there are two major drawbacks to this methodology. First, it assumes that no significant changes will occur to the company. For example, if a company was purchased for $100 million, but loses half of its revenue the next year, then its true value may drop down to only $50 million.
Second, because the analysis looks at past performance as a gauge for future success, it cannot take risk into account.
The step approach to business valuation is one of the most straightforward methods for determining the fair market value of a business. This method entails breaking down the overall business into its component parts or units, calculating each part’s intrinsic worth, and then combining all of these individual estimates into one number that represents the total market value of the business.
The components you use to break down the business depend on what information is available. For example, if you have access to financial records, websites, and/or chat transcripts, then you can calculate net profit, equity (ownership), average revenue per employee, and so on.
By using both internal and external sources, your estimate will be more accurate than either one alone. However, remember that not every source gives clear, complete numbers; sometimes it’s best to assume no profit when calculating net income or estimating capitalization rates.
When doing research, beware of over-estimating! Many entrepreneurs make the mistake of assuming that their own assumptions are too high, which only sets them farther from reaching an acceptable price.
The full business valuation approach is typically described as having three steps. These are to assess the market value of the firm, deduct the net asset value (NAV) of the firm, and then add in the intrinsic or personal value of the owner.
The first step in this process is determining the market value of the company. This can be done by looking at both internal and external sources.
Internal sources include information about the firm’s sales, earnings, assets, and liabilities. An estimate of the price that a buyer would pay for the company is taken from these numbers.
External sources include talking with people who work at the company or have worked at the company in past years. What they had to say about the company and their experiences working there are used to determine an appropriate price tag.