Business Valuation Methods

Business valuations can be used to determine the fair market value of a business for any number of reasons, including sale, establishing partner ownership, taxation, litigation, arbitration or even divorce proceedings. A business valuation may include an analysis of the business’s management, the business’s capital structure, the business’s past and future earnings, and the market value of business assets.

Methods of Valuation

There are numerous methods of valuation, but three of the primary methods of valuation are: the income approach, the market approach, and the cost approach. The income approach is based on the concept that the money an investor pays for an asset (or business) is a function of the amount of money the investor will receive over time as a benefit of ownership. Within the income approach are the capitalized returns method and the discounted future returns method. Alternatively, the market approach attempts to estimate the value of a business enterprise or an interest in that enterprise by comparisons with similar businesses and by comparison with exchanges of similar property in the marketplace. Within the market approach is the comparable sales method and the guideline company method. Lastly, the cost approach uses information from the cost of underlying assets or the assets in liquidation in order to value the business.

Some other trending methods include: Market Capitalization, which calculates the business’s value by multiplying the company’s share price by its total number of shares outstanding; Times Revenue Method, which applies revenues to a multiplier that depends on the industry and the economic environment; and the Discounted Cash Flow Method, which is based on projections of future cash flows that are adjusted to calculate the current market value of the company. While this list is by no means exhaustive, it includes some of the more common ways to value your business.

Common Errors in Valuation

There are various recurring errors that may happen during a business’s valuation. Courts have issued opinions regarding some major errors, including a business’s failure to hire an individual with the requisite education in order to conduct a competent valuation; the use of unreliable or inaccurate data; failing to obtain, or inadequate interpretation of, industry data; and failure to properly identify valuation methods when reporting business valuations. There are various other common errors to be wary of when accumulating and analyzing data, such as failure to evaluate marketplace transactions, failing to obtain compensation data, and failing to analyze legal agreements and documents of the business in order to determine limitations of the company’s value. Being aware of these common errors is key to avoiding mistakes during a business valuation.

Potential Outcomes

Valuation can be a complicated task as it is far from an exact science, and the valuation may have significant consequences for the company. A valuation set too low may devalue the company when it comes time to sell; and, on the other hand, a valuation that is set too high may damage the company’s ability to raise future capital, may also make it hard for initial investors to sell their holdings and exit, or may damage the company’s reputation. In preparation for the sale or acquisition of a company, the due diligence process may also affect the valuation of a company, thereby affecting the purchase price. A joint venture may also be affected by an improper valuation of contributed assets.