The Different Types of Business Valuation Methods, Explained

All established businesses will need to conduct a business valuation at some point in their financial journey. Whether you’re a small firm or a big firm, venture capitalist group, or investment banking company, business evaluations can help your company grow.

The evaluation process assesses the economic worth of your organization using various valuation methods.

The ultimate goal of an evaluation is to understand how your company is doing and what its future potential is. It is also helpful if you’re thinking of liquidating or reaching out to new investors.

Want to learn about how business valuation methods can benefit your company? Read on.

What Is a Business Valuation?

To put it simply, a business valuation is a process by which a company’s net economic worth is determined.

While there are numerous ways to value a business, the end objective is always the same. An objective assessment detailing all aspects of the company’s business must be reported at the end of the business valuation process.

Calculations about property, assets, equipment, projected earnings, revenue, and share price are all to be reported on the final assessment.

Why Is a Business Valuation Important?

There are many different types of valuation, all of which can be utilized for different purposes. Essentially, numerous factors contribute to the success of any company. By doing period evaluations, you can determine which aspects of your business are successful, and which need some help.

This provides your organization with greater growth potential, and the opportunity to improve each financial quarter. The three main reasons to employ valuation methods for your business are:

Understanding the position of your business will come in handy for various proceedings, such as taxation and finance.
Small business valuation methods provide a metric by which to gauge your business. Even if you’re just starting, conducting a valuation will provide a baseline or standard to refer back to.
A business valuation will help you determine the net worth of your business. This can come in particularly handy when you need to sell your business or propose a pitch to prospective clients.

In addition, business owners will benefit from the evaluation of their company because it makes it easier to add shareholders and establish partner percentages. It is also ideal for merger and acquisition purposes.

Understanding Value

Before we get into the various business valuation methods, it is important to determine the basis of value. Every type of valuation requires the setting of a base value. This could be defined as the parties upholding the transaction, or by law and regulation, or even the value between a willing buyer and a willing seller.

Ultimately, the purpose for the valuation and the basis of value is directly linked.

Most Common Valuation Methods

There will be different valuation methods for different kinds of businesses. Depending on your business situation, one specific method might be more beneficial than another, or vice versa.

What is of utmost importance to note here is that you’ll want to work with an appraisal professional. This is the best way to get an objective and reliable assessment so that you can focus on letting your business grow.

These are the 4 valuation methods that are most common in the industry.

1. Market Approach

This valuation method works best for companies that work in a competitive field with other similar businesses. The process involves comparing your business to another business that was recently sold.

This helps the appraiser determine the market value of your business in relation to what has worked in the market. This is only viable if there are a decent number of businesses that you can compare baselines to.

In addition, it can be difficult to implement for sole proprietorships, as it is relatively more difficult to find comparative data of similar businesses.

The market approach is also the most subjective of all the evaluation methods. It is also relatively imprecise. This is because factors such as location, products, assets, etc. differ from company to company.

Most businesses don’t make this information public knowledge, implying that the assessment cannot be a true comparison.

The consequence of this method is that the ultimate worth of your business can only be settled in negotiation. As such, it is not the best method for those seeking investors. However, it is a viable method for internal and industry assessment.

2. Asset Approach

This approach considers your business by subtracting the value of net liabilities from the net asset value. Appraisers will go through your balance sheet in great detail to help form the assessment.

There are two primary ways to approach valuations of this kind:

Going concern: This is the best approach for businesses that are not planning to liquidate any time soon. The formula assesses your current total equity. It does this by evaluating your assets minus any underlying liabilities.
Liquidation value: This approach is suited for those businesses that are planning to liquidate their assets. It sets a base value as the net cash, assuming the business was terminated and its assets were sold. The liquidation value in this method amounts to significantly less than what is considered fair market value.

Tailoring the asset-based approach to your business and its ambitions is ideal. The asset-based approach is advantageous in that it allows companies to operate on a premise of urgency (such as liquidation).

Metrics for evaluation in this method include cash, equipment, real estate, stocks, customer relationships, inventory, and more.

3. ROI Approach

While company valuation methods differ, ideally all of them should be assessing return on investment (ROI) in some form. The great benefit of this method is that it evaluates net value based on profit statements. This is suitable for suggesting what the potential ROI of the company is.

This method is ideal for those wishing to pitch to investors buying into the business. It allows investors to examine what kind of ROI they could expect from your firm.

However, this method faces the same problem as the market approach. A ‘good’ ROI is dependant on the market, leading this method to be ultimately subjective.

4. Income Approach

This approach evaluates a business based on its current, past, or future ability to generate income. It is also known as the business’s ‘economic benefit’. The three most common income evaluations are:

1. Historical Earnings Approach

This method is ideal for companies that are well established and have been in the market for a while. In fact, the longer your company has been in business, the more accurate your assessment.

This method three main factors: gross income, ability to manage debt, and current earnings. The more consistently your business remains in the green, the higher its estimated value.

On the other hand, if your business struggles to pay off debts and generate cash flow, it will be reported as having depreciated value.

2. Discounted Cash Flow (DCF) Approach

Although the four company evaluation methods mentioned above happen to be the most common, there are numerous additional options for youR business.

The DCF method utilizes financial data to assess net value. This approach is also known as the income approach and values a company based on its projected cash flow. This can be adjusted or discounted to its current value.

The advantage of the DCF method is that it requires considerable detail and careful calculations. This is useful if you are a new business, or operate out of a market that fluctuates greatly, as it can be used to evaluate companies whose profits are not expected to remain consistent in the future.

Although this method involves the most effort, it also results in the most accurate valuation. It also allows for the playing out of different financial scenarios and sensitivity analyses.

3. Capitalization of Earnings Approach

This method divides up a business’s expected earnings by the capitalization rate. This rate represents the risk associated with business investment. It also evaluates a business by how much revenue it is likely to generate over a specific period.

It uses metrics such as cash flow, annual ROI, and projected value to arrive at the new business worth.

This approach is ideal for stable businesses, as it is premised on calculations for a single period. The final assessment will indicate the overall ability of the business to be profitable.

There is also the ‘multiples of earnings’ (MOE) valuation method which falls within the capitalization approach. This method also determines new value by its future potential. However, the MOE approach calculates maximum worth by assigning a multiplier to its current revenue.

Multiples vary according to factors such as industry, economic landscape, etc. It is well suited for a smaller business.

How Can I Conduct a Business Valuation?

After exploring the four different valuation methods, let us look into how a valuation is conducted. There are 8 important steps to evaluate a company:

Utilize the services of a business appraiser: Most business owners have too much on their plate to handle a full business valuation. The process takes a lot of time and is technical and detail-oriented. This is why it is important to engage with a professional who will provide an accurate and reliable report.
Understand the purpose of the process: The main purpose of any valuation is to find the standard of value.
Determine the basis of value: As discussed above, the basis of value is crucial to how the assessment will go. Figure out whether your basis of value is set by law or regulation, as this will help the process in the future.
Gather data: Your business valuation professional is going to need lots of documents and reports to conduct their work. Keep your financial records, loans, leases, agreements, and contracts handy.
Review past performance: No matter which valuation method you decide to go with, you will need to evaluate your company’s past and its previous net gains. This allows for easier comparison and projections.
Set a business goal or outcome: Every valuation must have a purpose. For example, it could be to sell your business or attract investors. Determining how and when you want your business to grow will always come in handy. Ask questions about management, future projection, value creation, and impact. This will help you arrive at a business plan that you can base your valuation on.
Determine the valuation approach: Your appraiser will help you select the most appropriate method for your unique business needs. This is when the data and analysis come together, helping form the final assessment report.
Arrive at a net value: This is the final step of the evaluation process. Your appraiser will provide you with a comprehensive report with a conclusion of value.

Although the process can often be time-consuming and difficult, it is well worth it to have an accurate and objective appraisal in place. This valuation will serve your company for many different scenarios and help it move towards overall growth.

The Bottom Line

While business valuation is a complicated and lengthy affair, it is also extremely beneficial for most businesses.

There are so many valuation methods to choose from, but ultimately, you’ll have to go with the approach that makes the most sense for you. Combining multiple business valuation methods is also an option.

It is also critical to hire a knowledgeable professional before you embark on an evaluation. At Dolan Sales, we are specialists in the valuation business and have extensive experience and years of practice with different business cases.

Don’t hesitate to contact us for all your business evaluation needs and to learn more about the different valuation methods.