When it comes to valuing a business, most owners tend to think of it as a simple calculation of assets and liabilities. A business valuation is more complex than that. And what your business value is will depend on a lot of different factors.
Quite often, owners tend to undervalue their business due to a lack of understanding of what business value truly is and the ideal business valuation methods. There is no single methodology that is most suitable for every business. To conduct a business valuation properly, you need to understand the different valuation methodologies and when it is appropriate or not suited to your specific situation.
Assessing the appropriateness of business valuation methods to be used follows four key factors:
- the purpose of the valuation
- the nature of business being valued in terms of earnings, cash flow, and risk
- the users of the valuation report
- the ongoing concern status of the enterprise
Three of the most common methodologies when valuing a business held in private entities are the asset-based approach, market-based approach, and income-based approach.
The asset-based approach, as the name suggests, assumes that the business value is equal to the net tangible value of operating assets held by the business at its current value in use. To put it simply, this approach follows the formula:
assets – liabilities = net asset value
So, your business value depends on how much you have after all your debts and other dues are settled.
Although this approach is simpler, it does not capture the value of intangible assets such as a well-respected brand, customer goodwill, intellectual property (such as patents or protected designs), and potential for growth. This approach is more appropriate if the business has little to no goodwill.
Market-based valuation methods typically compare the business being valued with another business where the valuation is known. We often look at listed entities and public data of businesses in the same industry to assess the value of the business. We use this as some proxy for the business being valued or look at actual transactions where the details are known. This business valuation method is often called the comparable transactions method and can be useful in cross-checking other valuation methods.
One drawback of this approach is that data is not easily available, especially those of private companies.
The income-based valuation method assumes that the value is based on the profits or free cash flow that it can provide to the business in the future, as well as the unique risk factors associated with that income. Essentially, this business valuation method focuses on the future financial performance but also takes the business’s historical actual performance into account.
There are three income-based methodologies commonly applied in business valuation:
- Discounted Cash Flow methodology (DCF)
- Capitalisation of Future Maintainable Earnings (CFME)
- Industry Rule of Thumb
The Discounted Cash Flow methodology (DCF) assumes that the business value is equal to the present value of its expected future free cash flows into perpetuity. DCF estimates the business value based on forecasts, considering key variables such as discount rate, future cash flow, time value of money, etc.
Capitalisation of Future Maintainable Earnings (CFME) is a single period version of a DCF methodology in which the business valuer determines the value of the business based on the sustainable profits it can generate in the future.
The Industry Rule of Thumb approach assumes that a standardised valuation method is used for all participants within an industry. Typically, this uses a multiplier of an income stream (revenue, gross margin, earnings before interest and tax or EBIT, etc) to determine the business valuation range.
Your business value lies on a heap of factors. And there can be many other methods used when valuing a business. This is why it’s extremely important to understand how business valuations work and plan ahead so you don’t end up undervaluing your business.
Do you need help with a business valuation? Get in touch with our Valuation specialists for a Financial Performance Analysis that helps you understand your current position and to understand which business valuation methods are right for your circumstances.