What is Business Valuation and When do Businesses Need it?

A business valuation indicates the economic value of a business or in simple terms, its market worth. Usually, business valuation is a preferred tool for measuring a company’s value when there is a sale, liquidation or merger taking place.  There are professional business valuations experts who undertake the estimation.

Why business valuation?

It helps in determining the market value along with the analysis of the company’s management and its other aspects using objective measures and other techniques. The capital structure, future earnings prospects and the market value of assets are also taken into account.  Business valuation also depends on the factors of the industry, sector and the valuation method used by the professional evaluators.

Business valuation helps in case of debt or equity financing for expanding operations or cash flow crunch. It is useful information for potential investors or shareholders who wish a buyout.

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Methods of business valuation:

Typically, there are three approaches when conducting a business valuation:

1. Asset approach
2. Market approach and
3. Earnings value approach

Asset approach:

As the name suggests, this approach focuses on the assets and the liabilities of the business. There are two methods in the asset approach namely:

• Going-concern method where the assets are subtracted from the liabilities from the figures derived from the final balance sheet.
• The Liquidation asset approach the total cash a business would receive if the assets are liquidated and liabilities settled.

However, the asset value approach is suitable for sole proprietorship as the personal assets of the owner are included in the balance sheet and separating them will be difficult.

Earning value approach:

Earning value approach advocates that the true worth of a business lies in its future earning capacity. There are two methods of deciding a company’s value using this approach:

• Capitalizing past earning:

In this method, the evaluators calculate the expected level of cash flow by multiplying past earnings with a capitalization factor. The capitalization factor is determined by scrutinizing the rate of return on investment and the risk rate of achieving that return.

• Discounted Feature earnings:

This method uses the average of the trend of the predicted future earnings that is divided by the capitalization factor. It gives the value of the future earnings offset by the risk of achieving those earnings.

Market Approach:

This method attempts to place a value on the business by comparing it to its competitors or similar business recently sold. The downside of the method is that it only works if they are a sufficient number of businesses to compare to and it is not suitable for sole proprietorship.

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Benefits of  business valuation:

1. Knowing the true value:

A person may have a general idea on how much his/her company is worth by calculating the general facts of the market value, total asset value and bank account balances. Even though these numbers might give a general idea, they do not reflect its real value. By knowing the correct value, it is easier to gauge the potential buyer’s interest in purchasing the company and aids the owner in securing a better deal.

2. Better knowledge:

Obtaining specific numbers of the assets helps in getting the proper amount of insurance cover, knowing the reinvestment requirements and what is the amount of profit a person gains even after the sale of the company.

3. Company resale value:

Being aware of the company resale value aids in negotiations and in getting a profitable deal. This process of valuation should be the first step before marketing the company. It helps in solidifying the company’s stance in getting the best price.

4. Mergers and acquisitions:

Mergers and acquisitions are common in a business cycle. By conducting a business valuation, the company owners can show how much the business has grown in the past years, its asset holdings and its potential. When major corporations attempt merger or acquisition, they will start only at the lowest price; but a proper valuation will help the company to assert their position.

5. Lure investors:

The ultimate aim of any investor is to gain substantial profits from their investments. Whether to save the company from financial problems or fund company growth, the investors require a full valuation report with projections and charts giving a detailed view. That is where a business valuation helps, and the investors can see how their fund will help the business grow and generate returns in the future.

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There are different kinds of business valuations, and the evaluators use a combination of these techniques to find out the value. Most experts recommend that businesses should opt for an annual appraisal as it helps them not only know its real value; but also set goals to increase their growth and improve the lacking areas. Understanding the actual value of every facet of the business and its worth is instrumental information for the business owners.