Business valuation is defined as a way to determine the overall economic value of a company, and is a necessary component of a sound business plan and strategy. Reasons for a business valuation run a gamut from selling the business due to retirement or health reasons to financing expansion efforts to adding shareholders to a buyout situation.
Any of these situations will demand a valuation to determine current and future projected value.
Three Methods of Valuation.
When determining the value of a company, valuation will fall in one or more of three central categories:
Asset Based – This method contains two more breakdowns in consideration:
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- An asset-based method of valuation looks at the numbers without an excess of consideration for context or extenuating circumstances. Simply put, this approach lists a company’s total assets, deducts total liabilities, and determines overall value based on the difference between the two.
- Also referred to as Book Value
- A liquidation asset-based approach determines the value as confirmed by the net amount the company would be worth if all assets were sold and all liabilities paid off immediately.
- An asset-based method of valuation looks at the numbers without an excess of consideration for context or extenuating circumstances. Simply put, this approach lists a company’s total assets, deducts total liabilities, and determines overall value based on the difference between the two.
An Earnings Based approach to valuation is predicated on the concept that a business is only as valuable as its potential to produce value in the future.
This method branches off into two schools of thought:
Past Earning Capitalization – this suggests that the expected revenue in the future can be predicted by a record of the company’s past earnings, once undue revenue or expenses are accounted for and multiplies the projected earnings by a capitalization factor.
Discounted Future Earnings – This is a value approach to business valuation that dictates that instead of an average of past earnings, the value of a company can be determined by averaging predicted future earnings divided by a capitalization factor.
Capitalization Factor – This can be defined as a multiplier used for converting projected future earnings and revenue into present day value. Also known as a cap rate, it can be used as a way to measure risk and anticipated return on investment (ROI).
Market Value Approach – The Market approach to valuation focuses on attributing value to a business based on the value determined by free market forces in situations that are similar to those the business deals in. A comparable situation might be previous transactions in the same business. Market approach is a fairly fluid valuation in that it assesses value relative to previously valued transactions.
Why You Should Have an Up to Date Business Valuation.
Life happens to all of us. Proper preparation for unforeseen emergencies can save a lifetime of misery on the far end. At any time, any of us could be hurt or killed through no fault of our own and with no warning. Just as you maintain life insurance and other emergency coverage, you should also keep your business valuation current, and update it regularly.
It’s Not All Bad News.
It doesn’t have to only be a doom and gloom situation, however. There are a variety of ways an up to date business valuation can work to your advantage! A current business valuation allows you to add a partner to your organization, or take advantage of an opportunity to strengthen your organization by way of a joint venture. “At least 30% of our clients are people who sold their business and moved somewhere they’ve always wanted to live,” says Mark J. Strohl, CPA and founder of Protax Consulting, a firm that offers tax services to expatriate Americans, “everyone wants to live someplace warm and beautiful.” With a properly valued company, retirement to that tropical paradise could be just around the corner!
When you’ve properly valued your business, you can use that valuation as collateral for a loan or new equity to expand operations, or establish another location. A current and comprehensive business valuation gives you options, and with sufficient options available, there is virtually no limit to what you can accomplish.
Never Confuse Business Value with Asset Value.
Since you are likely not a financial wizard or business accountant it is possible that you may have made the biggest mistake a business owner can make when it comes to valuation. Namely, you should never associate asset value with business value. Let’s say you’re selling an accounting firm and it has an office block worth $500,000, with supplies – computers, office furniture, TV screens, etc. worth $50,000 and another $250,000 in financial backing. This gives you $800,000 in capital assets, meaning if you liquidated everything, the cash value of it all would amount to $800,000.
Are Capital Assets Useful For Valuation?
There are schools of thought that would say this is the worth of your accounting firm. While this information is not incorrect, it is most certainly not the worth of your accounting firm, it is how much cash is tied up in your business. For a buyer or investor interested in acquiring or investing in your firm, this isn’t the number they care about. They want to know how much money your firm will generate going forward by way of the services you perform and the number of clients you serve. When it comes to business valuation, throw capital assets out the window, it is simply not going to help you.
Profits: The Bottom Line on the Value of Your Business.
Simply put, the valuation of your company is about the revenue you are currently generating and the revenue you are likely to generate in the future. A buyer cares about the revenue your company will generate going forward if they should decide to take the reins. To formulate your profitability, you must take into consideration all outgoing payments like payroll, and your gross income, yes even your own salary. We are looking for net profits here, so all expenses must be accounted for.
Once we’ve established your profit, it is time to predict future profitability. Since we know our business will be valued not on its profit for a single year, we have to consider ways to predict future earnings. One way to do this is by profitability adjustments. Since we can assume a company is likely to continue on, we can look at how much money the company brings in currently, and do what’s called profitability adjustments. Revenue tallies will usually fluctuate from year to year based on company practices, consumer spending habits, the economy, etc. When valuating your business, you should estimate what sort of growth or loss you can expect throughout an expected period of time.
Multiples.
If the profits of your company are expected to grow at a particularly vigorous rate, purchasers may be willing to consider paying more than a straight 1 to 1 valuation of your business. This is called a multiple. A multiple calculates an aspect of a company’s financial value by dividing one performance metric by another performance metric. In other words, if you own a software development firm that also trains developers, and you believe that combining the two services will lead to greater revenue generation over the course of time because app development is a currently expanding industry, you can ask for a multiple of 1.5. This means that if a purchaser were buying your firm for 1 million dollars, he now needs to pay 1.5 million dollars, because your software development firm is expected to generate enough revenue over time to offset that.
This has been only a small primer on business valuation and its applications for entrepreneurs and other business owners to build wealth predicated on what they have already accomplished. This should be considered a jumping off point for your own research into business valuation.
Happy wealth building!
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