Business valuation is a process of estimating the economic value of a business or specific company unit. Business evaluation can be carried out for several reasons like selling, establishing partner ownership, evaluating tax, and divorce proceeding when business is divided between parting partners. You can also perform business valuation to apply or qualify for loans.
Business valuation methods
The valuation of a business depends on various factor and vary business to business. There are numerous methods for business valuation, some basic methods of which are discussed below.
Market capitalization
It is estimating a company’s value by determining what the market thinks about a business. Market capitalization depends on two factors its share price and total outstanding shares. Market capitalization determines the size of a company and shows various determinants in which investors might be interested. A company’s initial market cap is established via IPO.
Example
The market capitalization of a company having £1000 outstanding shares selling at 100 a share will be calculated as:
share price x shares outstanding = Market cap
£1000 x 100 = £100,000
Times-Revenue
This method is used to establish the maximum value of a company. It is calculated by multiplying revenue generated in a certain period with a multiplier. A multiplier may vary according to the type of the business and its economic environment. Time-Revenue is not always a reliable indicator as revenues are not profits and an increase in revenue doesn’t mean an increase in profits. For small businesses estimating times revenue might also aid in financial planning.
Example
A software company may be valued 3 times its revenue due to its trending environment. Whereas a company that manufactures stationery may be valued 0.5 times its revenue due to its deteriorating trend.
Earning multiplier
The earning multiplier is a useful tool to determine the relation of the stock prices to the company earning per share (EPS). This relation is important in indicating the optimal time for buying a company. If a share of a company is expensive as compared to EPS that means it is not the optimal time to buy a company.
Example
A company has a stock price of £10 per share and EPS of £2, the earning multiplier would be calculated as:
Current share price/EPS=time for making back the stock price
£10 / £2 = 5 years
You might need to factor in other possibilities to calculate earning multiplier. For more information click here
Discounted Cash Flow Method
This method evaluates the future benefits of an investment. The DCF has its limitation in evaluating the value of the business as it only indicates future cash flow. Investors can use this method to determine whether they will make a profit or loss from a certain investment.
Example
Consider you have £100 in your saving account with an interest rate of £10% per year. It will be worth £110 in a year. Similarly, if a £100 payment is delayed for a year, its present value is £90 because it can’t be put in your saving account to earn interest.
Formula where:
CF = The cash flow for a given year
CF1 is for year one while CF2 is for year two
CFn is for additional years
r = The discount rate
Book value
The net difference between companies’ total assets and total liabilities is the book value of a company. Book value also determines the share of shareholders in company assets if the company were to be liquidated or in indicating if a stock is under or overpriced.
To estimate the accurate value of assets, mark to market valuation shall be factored in. If the mark to market value is not factored in, an increase or decrease in the market value of an asset might be experienced. whereas Price-to-Book ratio can be used as a multiple for value comparison within similar companies.
Liquidation Value
The net worth of the total physical assets of a company is known as liquidation value. It determines the final value a seller of asset receives on selling an asset. Whereas intangible assets are not included in liquidation value. It is important to know most investors access your Liquidation Value to evaluate how much their investment will return in case of liquidation.
Type of assets contributing to business value
Tangible assets – Assets of a business are physical assets that can be measured for value. These assets include machinery, equipment, and stocks.
Intangible assets – Assets that do not have any physical attribute and are not easy to evaluate for a value. There are sizeable intangible assets that can be valued in a business. These intangible assets are trademarks, reputation and brand name, etc.
Factors affecting business value
Some factors that might affect business value during a sale are:
- Profit growth rate – if business profits are growing constantly, it is likely the business will be valued more than its business value.
- Type and time period of contracts – longer and well-drafted contracts bring higher value to a business.
- Consistency in profits – a business with consistency in profits is valued more than a business having inconsistent profits.
- Market trends – the market trend of products a business is offering plays a vital role in determining its value.
- Prospect buyers – businesses having a larger number of interested prospective buyers have more business value than those businesses having smaller numbers.
- Reason of sale – if a buyer sense seller urgently needs to sell a business, this is likely to impact business value.
