What’s My Business Worth? | An Inside Look at Business Valuations
Published on by Harold Kremer in Advisory, Consulting, Transaction Advisory
When you’re buying a business or considering your exit options, understanding the entity’s true market value is essential and a business valuation is a key part of that understanding. A business’s value is based on several variables, including business size, market volatility, macroeconomic trends, and industry growth forecasts. In this post, we’ll take a look at situations where a business valuation is called for and the methods for conducting a valuation.
When do you need a business valuation?
Buying or selling a business is a common situation that calls for a business valuation, but there are others.
Financing
A business valuation can provide critical insight for obtaining a loan, securing new investments, or attracting more partners to the business. Business valuations can tell banks what it’s safe to lend. It can also help secure investment in a business – sophisticated investors are looking for opportunities to increase value and adequate data to make smart investment decisions, and a well-supported business valuation can build confidence with these potential investors.
Mergers and acquisitions
Mergers and acquisitions (M&A) refers to the combination of two businesses. Information obtained from public companies performing transactions and private equity firms buying and selling companies provides insight on reasonable transaction models.
Gift and estate tax planning
In gifting and estate planning, understanding the fair market value – the price at which an asset would change hands between a willing buyer and seller with reasonable knowledge of the facts – is crucial. The valuation is based on the information which could have been reasonably known on the valuation date. It’s important in the types of valuations to understand IRS requirements for documentation and IRS stance on discounts that can be applied to value.
Legal disputes
Shareholder compensation, settlements, or ownership disputes may require a valuation as well. If a contract is breached, a valuation can determine the level of financial harm that may have occurred. Intellectual property claims, such as trademarks or patents, may also need to be supplemented by a business valuation to quantify damages or fees.
Divorce
Dividing marital assets may also require a business valuation – if the business is owned by one or both spouses, a valuation helps ensure proper asset distribution. Understanding family and related party transactions is important in analyzing a company for divorce purposes.
3 methods of business valuation
There are three approaches for determining a business’s value: the market, income, and cost approaches. Each approach evaluates factors differently, and the nature of the business and the reason for the valuation can determine which method is appropriate.
The market approach
The market approach involves analyzing the business and comparing it to other similar companies based on publicly available data. Ratios, such as the price-to-sales ratio or price-to-earnings ratio, are considered based on industry standards. Adjustments to ratios are sometimes required due to the differences in company size and consistency of reported data.
The income approach
If the business has a documented history of earnings and cash flow, the income approach can be used to estimate the present value on anticipated cash flows the entity is expected to generate in the future. This can be done by conducting a trend analysis, where historical growth patterns are extended to create future predictions. Your valuation professional may also choose to use industry data to help predict growth rates and reasonably expected profit margins.
The cost approach
Some businesses are more asset-intensive than others – construction companies, for example. Other businesses may be losing money currently or have reported inconsistent earnings or losses in the past. For these businesses, the cost approach may be the best option. This method places a value on the business based on what it would cost to replace the assets. The process starts with identifying all tangible assets: machinery, equipment, land, buildings, inventory, furniture, etc. Determining the current replacement costs should consider market prices, expected asset depreciation, location, and other relevant factors. Some intangible assets may also be factored into the valuation, including brand value, patents, or customer lists.
Next steps
Ready to know what your business is worth? Set up a free consultation with one of our certified business valuation pros. They can help you determine which method is right for your circumstance and guide you through the often complex business valuation process.
