How to Value a Business
Getting the best business valuation is essential if you want to find an investor wishing to fund startups. But how do you know the right time to get a business valuation, and what are the most important factors to consider?
It can be complex to determine a market value for your company.
Perhaps you need a business valuation to source financing for developing your startup. Investors are especially interested in funding startups because of their rapid growth potential compared with more established mature companies.
Before considering a business valuation, it's essential to assess the current market for your business industry. For instance, tech companies are attracting lots of interest from investors who want to fund startups right now.
If the market for your business is currently in a downtrend, it may be preferable to wait. A company is only as valuable as the market dictates or how much an investor is willing to invest in businesses.
The alternative is to assess what makes your business distinctive from competitors, your USP, all of which can factor into a valuation.
So now you're ready to proceed with a business valuation, where do you begin? What are the critical areas of business focus? Do you need to hire a professional business valuation expert, or can you do an in-house business valuation?
What is a Business Valuation?
A business valuation is about assessing the total value of your company, weighing up the economic value and the company assets and subtracting company debts to procure an accurate business value.
There are many reasons to determine the value of your business -
- Secure funding - to expand the business, plan to do an annual valuation to prepare for future eventualities.
- Tax purposes for tax returns.
- Secure investment – investors want to see the realistic market value of a startup before they invest in businesses so they can assess current performance and growth potential before investing.
- Set a fair price for employees – to buy and sell shares in the company
- Sell the company – if you're ready to sell, a business valuation is essential.
- Partner leaving the business – if a co-founder wishes to leave the business, a valuation is necessary.
- Liquidation – unfortunately, many startups fail, and liquidation value helps close up the business, pay creditors etc.
How to Calculate Company's Value
There are numerous ways to calculate the value of a business. In this post, we'll look at six methods of business valuation that measure a company's financial standing.
1. Book Value
The book value is the simplest method of valuing a business by using data from its balance sheet. Though it's the easiest of the valuation options, it's not 100% reliable.
To calculate the company book value, subtract the liabilities from the tangible company assets, such as stock, property, computer equipment, etc., and then exclude intangible assets (which can be the trickiest to determine value).
The final figure is representative of the value of company-owned tangible assets.
The book value method is unreliable because you cannot equate the balance sheet figures with value. Because of the principles of conservatism and historical cost accounting, the metrics don't represent an accurate assessment of the actual value of a company.
Investors that want to fund startups may request a more accurate evaluation.
2. Market Capitalization
Market capitalization is a simple process for a business valuation for publicly traded companies, whereby you calculate the total number of shares by the current share price.
Market Capitalization = Share Price x Total Number of Shares.
It is not, however, foolproof because it only measures equity value. The market capitalization method doesn't factor in company debts, such as bank and bond investors. So even though the company pays off liabilities with interest over time, it's not an actual business value.
So the market capitalization method can only be considered an overview of the business value, not taking debts into account.
3. Discounted Cash Flows Analysis
Discounted cash flow analysis estimates the value of a company based on the expected future cash flows.
This process calculates the present future cash flows value based on a specific analysis period and discount rate.
Discounted Cash Flow = The Terminal Cash Flow / (1 + Cost of Capital) Number of Years in the Future
One significant benefit of the discounted cash flow method is that it demonstrates how well a company generates cash. But relying on terminal value is based on assumptions of future discount rates and business growth. Nobody can predict future company growth accurately, so a discounted cash flow analysis is not 100% reliable.
4. Enterprise Value
The enterprise value method is a more reliable method of business valuation than the previous three methods.
Enterprise value is assessed by combining the company's debt and equity and deducting bank held cash (because the cash isn't part of the daily operations).
To show how enterprise value works, let's look at Tesla car manufacturers as an example.
- In 2016, Tesla had a market capitalization of $50.5 billion
- Tesla's balance sheet showed $17.5 billion in liabilities
- There was $3.5 billion in cash in its accounts.
- Calculate the above three figures: Debt + Equity – Cash = Enterprise Value
- Tesla, therefore, had an enterprise value of approximately $64.5 billion.
The enterprise value is a more effective and reliable business valuation method because it combines several business valuation methods and accounts for cash and company liabilities.
5. Price to Earnings Ratio (P/E)
The P/E Ratio (price to earnings ratio) is a process of valuing a business with a measurable and established track record of company profits.
The P/E value is higher for companies with a high-profit forecast, such as tech companies. More established businesses with steadier growth will likely have a lower P/E ratio.
For example, a company with a P/E ratio of two with $500k post-tax profits has a value of $1 million ($500k x 2).
Many variables determine the P/E Ratio. Business experts suggest that a P/E ratio of between four and ten is optimum for a company to attract business investors interested in funding startups.
Investors often prefer to invest in businesses with a higher P/E ratio because the benefits of funding startups' are the significant growth potential.
6. The Times-Revenue Method?
Sometimes called the 'multiples of revenue method', the times-revenue process uses multiple current revenues to determine the maximum business value over a predetermined period and creates a value range by assessing sales cash flow.
Depending on the particular industry and the economic business environment, the multiple could be one or two times the actual business revenues. In some cases, the denominations could be less than one.
This method works best with companies with zero earnings, volatile startups and fast-growing companies such as SaaS firms, often valued at three to four times the revenue range.
As a business valuation approach, the times-revenue method is not 100% reliable as it's a means of valuing business revenue rather than a company's profitability. And, as you know, revenue increases don't necessarily equate to higher profits.
Results depend on the current market for the specific business industry, the macroeconomic environment, and other factors.
From the six examples of business valuation methods, we can identify the challenges of getting the right business valuation so you can find funding from investors ready to invest in businesses.
Undoubtedly, the most reliable option for business valuation is to hire an expert.
Hiring a Business Valuation Expert
Valuing your business can be a challenging process, and it's easy to miss essential factors of the valuation if you're trying to do it yourself.
A business valuation professional is an expert solely focused on getting the best valuation for your business.
It's best to work with a recommended business valuation expert. Usually, the accredited advisors are from accounting backgrounds that choose to specialize in business valuation.
Every country has country-specific accreditation for business valuation, and that's a great place to start.
For example -
- United States – Accredited in Business Valuation (ABV)
- Canada – Institute of Chartered Business Valuators (CICBV)
- Global – ACCA Global Certificate in Business Valuations
There's an optimum time for a business valuation, and it's essential to have your business ducks in a row by assessing the current state of your business.
Make sure that company processes are streamlined, effective and easy for a potential investor to assess.
Dig down into your customer base to check that the business income isn't weighted to a few select clients. If that's the case, aim to spread the risks by diversifying your customer base.
Finally, strategize how you plan to achieve short-term and long term goals.
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