What Are the Different Business Valuation Methods?
The more than 33 million American small businesses stand as a testament to the entrepreneurial spirit in the national character. This spirit is often seen most clearly in urban areas. With higher population concentration, you get more people looking to start businesses.
Yet, even die-hard entrepreneurs eventually reach a point where they want to do something other than running the businesses they started. With 60-hour weeks a norm for many business owners, it’s hard to blame them.
If you sell, you’ll need a business valuation. Let’s look at some of the common business valuation methods.
Business Valuation Uses
The most obvious reason that someone gets a business valuation is for the purpose of getting a target price range for when they sell the business. That is not, however, the only reason for getting a valuation. Other common reasons include:
- Tax purposes
A business owner might even want one as a sanity check before they take out a major loan.
Business Valuation Basic Procedure
Before agreeing to a valuation, it’s helpful if you understand the function of and procedure for a business valuation. The main function of valuations are for the seller or a buyer to get at least a semi-objective sense of the raw value of a given business.
The procedure for a valuation is relatively straightforward. It has five general steps.
1. Scope Determination
The scope determination step is mostly about getting clear on what exactly the valuation company is there to set a value for. For example, are they doing a valuation for the whole business, a subsidiary, or something else?
As a general rule, this also involves assigning a value date. Since values can change over time, the company must pin the value to a specific time in the past.
2. Producing Documents
The next major step in the process is for the business to produce all the relevant documents. The valuation service will provide specifics about what documents it requires, although those may vary based on the types of business involved.
The valuation service will then conduct an initial analysis using one of the common valuation methods. See below for more about methods.
4. Management Discussion
Following the initial analysis, the valuation service may request a follow-up discussion with management. These discussions usually seek additional clarification or information that the service couldn’t glean from the documentation.
5. Final Report
Following the management discussion, if it happens at all, the valuation service will then issue a final report. This report will contain the business’s value based on the service’s analysis.
The speed of this process can vary tremendously based on factors like business size, industry, and exactly how complex your business finances are at the time of the valuation.
Now, let’s look at some specific valuation methods.
If there is a quick and dirty version of business valuation methods, the book value method is it. This approach starts by looking at all of the assets that are on your business balance sheet. Then they add up the total value of those assets.
Next, they look at all the liabilities on your balance sheets. Then, big shocker, they add up the total value of those.
Finally, they subtract the sum of the liabilities from the total asset value. Whatever is left is the business’s value.
Given the ease of manipulating asset and liability numbers on a balance sheet, this method isn’t a particularly reliable one. It’s best used as a ballpark figure.
The liquidation value method shares some features with book value method, in that both deal with assets and liabilities. The liquidation valuation makes a calculation about what would remain if you sell off all of the business assets and settle up for all of the liabilities. The business value is whatever is left over.
Discounted Cash Flow
The discounted cash flow method is often viewed as one of the better valuation approaches. This approach essentially attempts to project future earnings from a business.
If that sounds like a complicated problem, it is. The valuation company must make a substantial number of informed assumptions about everything from the business itself to economic conditions, social conditions, and even what will happen with the environment.
Given these assumptions and weighing the risks involved with a given industry or a particular kind of business, the valuation service will apply a discount rate to these future earnings. Those calculations, including the discount, let them estimate the current value of the business.
The market value method typically takes one of two main forms. In the more basic form, the valuation company finds the stock price at a given time, such as the most recent tax day, and multiplies that price by the total stock shares for the business.
The more complicated market approach seeks to find the business’s relative value. This typically involves an in-depth comparison with a similar business or company. For example, they’d look for a company in the same industry, of about the same size, and ideally providing a very similar set of products or services.
It’s important to understand that all of these approaches have limitations.
You should discuss the pros and cons of the approach your valuation service will take before you agree. In fact, it’s generally for the best if you get at least two or, even better, three valuations using different valuation methods. If multiple valuations all put the value of your business in the same general area, it’s probably a reasonable price to ask.
Business Valuation Methods and You
When you do finally decide that it’s time to hand up your current entrepreneur’s hat and sell, you need a starting point for your asking price. The business valuation methods above can provide you with that starting point.
Just remember that these valuation methods are, by nature, imperfect. They’re often constrained either by time or by unavoidable assumptions of future conditions.
Fusion Business Services can help you sell your St. Louis business. For more information about what we can do for you, contact Fusion Business Services today.