As your company grows, calculating the monetary worth of your business helps towards creating strategies based on a deeper understanding of one’s standing in the market as well as future sales prospects. Be it with the intention of selling your operations tomorrow, or just to figure out your position amidst your competition, knowing the value of your business helps. For this, several business valuation methods are in place, each designed to help you calculate the worth of your business or company.
One may need such a fiscal calculation for various reasons. This includes the sale of the business, partnership formations (including new inductions and withdrawals), and even the divorce proceedings.
For instance, you may find yourself in a partnership where one of the partners wishes to withdraw their shares. In such a case, you would need to know the current value of your entire operation to calculate what the business owes to the outgoing partner. Similarly, if a new partner is introduced, the value of the business would need to be taken into account when deciding the terms, conditions as well as the capital investment demands.
An accurately calculated business valuation report always comes in handy. These results can help in negotiating deals with the suppliers and lenders, giving you a true picture of what leverage you hold in the market.
Business Valuation Methods
A Business Valuation is a process of calculating the economic worth of your business. Depending on the nature of the business and its requirements, this monetary worth can be calculated in three different ways.
The results of these approaches can be vastly different from each other. Each method is meant to cater to a specific set of conditions. Therefore, it is imperative to fully understand your situation and the needs of your business.
The three methods of business valuation are:
- Asset-Based Method
- Earning Value Method
- Market Value Method
Asset Based Method
As the name suggests, this business valuation formula relies on the assessment of the value of the business’ assets. In other terms, it calculates how much investment the business currently holds. This can be performed in two ways.
In the first method, called the “Going concern asset-based method,” evaluators will work out the net value of the business assets on the balance sheet, and subtract it by all the liabilities the business holds.
Taking an entirely different approach, the other method determines the amount of net cash a business would receive if all its assets were sold off, and all its liabilities cleared. This is called the “Liquidation asset-based approach.”
The asset-based methods are more suited to businesses that make a clear distinction between the assets of the company and its owners. For example, it wouldn’t be a suitable approach for a sole proprietorship business, as all the assets in such a business are owned by that sole proprietor, who is at liberty to employ them either for the business use, or their personal use.
In contrast, in a corporation, the company has a separate identity and is in fact, an artificial person. All the assets of the business, in this case, are owned by that identity, which is the company itself.
Earning Value/ Income Method
In this approach, the value of a business is determined by calculating its potential to generate income in the future. This is done by processing the business’ past performance and financial records and using the results to forecast the financial future of the company.
This is called “Capitalizing Past Earnings.” In simpler terms, based on past earnings, the revenue generation potential of the business is calculated, predicting how much the business would amount to after a certain period.
A separate method in the income-based approach is called, “discounted Future Earnings or Discounted Cash Flow (DCF).” In this method, instead of assuming future earnings based on records, calculations are based on predicted future cash-flow. These predicted numbers are then adjusted to the current rates, allowing for a current value of the business to be calculated.
A company opting for this business valuation method must have established operations with a considerable part of revenue generation. Even if you are calculating the value of your business through discounted future earnings, the approach would require you to have some goodwill in the market, some history of clients, and a system of revenue generation in place to base your calculations on.
Market Value Method
This is a pretty straightforward method – the value of your business is determined by comparing its sales and market performance with that of a similar business.
For example, if a lot of your competitors sell their operations, a specific buying rate would come to exist for a business like yours in the market.
If you want to work out the value of your business, simply look at the how much your competitors sold their businesses for. This figure would show you how much your business is worth out in the market if you were to decide to sell your operations today.
This approach best suits a highly saturated industry where there are frequent buyouts.
Which Business Valuation Method to Choose
It is important that the business valuation technique you select not only suit the nature of the operations but also fulfills all the legal requirements.
For instance, although the earning value method is a completely legitimate way of calculating the value of a business, you have to have some solid foundation for your calculations.
All assumptions must be based on tangible factors and acceptable records. The forecast shouldn’t be based on anticipated factors that have no promise of taking place at all.
For example, the Delaware Chancery Court observations in Huff Fund Investment Partnership v. CKx, Inc case of 2014, read:
“When management projections are made in the ordinary course of business, they are generally deemed reliable. But the Court has disregarded management projections where the company’s use of such projections was unprecedented, where the projections were created in anticipation of litigation, or where the projections were created to obtain benefits outside the company’s ordinary course of business.”
Similarly, it is important to understand that the valuation of small businesses will be completely different from the process for a larger operation. For small businesses, factors like unclear ownership of assets, reliance on sole proprietorship, and even lack of credible records come into play.
But since over 90% of businesses are small and medium enterprises (SMEs), it is a highly saturated sector. In such a case, instead of employing an asset or income-based approach, it would be wiser to take on a market-based approach.
Business valuation has wide-ranging uses, from its critical role in the transference of ownership to helping orchestrate strategic maneuvers – acquiring loans, expansions, and even mergers and acquisitions.
It is imperative that the approach and method adopted be carefully selected as the wrong calculations can lead you to significant financial losses in the future.