written by | September 28, 2022

Business Valuation: Definition, Methods, & Examples

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Table of Content


The business valuation definition will suggest that it is the process of determining the current value of an asset or a company. A valuation can be done following numerous techniques. Analysts who need to put a value on a company analyse the management of that specific company, the market value of the business assets, the prospective future income and the composition of the capital structure.

What is Business Valuation? 

Business valuation meaning will suggest business valuation determines a security’s fair value, which is dependent upon the amount the buyer offers to pay the seller while settling that both parties want to enter that transaction. During the trade of security regarding an exchange, the buyers and sellers dictate the actual market value of a specific stock or bond. On the other hand, intrinsic value refers to a perceived value of a security based on future income and other attributes of the business that are separated from the security’s market value. Thus, analysts need to know if a company or asset is overvalued or undervalued in the market before determining the valuation. 

Valuations are often done on liabilities or assets such as company bonds. These are required for acquisition and merger transactions, investment analysis, capital budgeting, financial budgeting and litigation. 

Also Read: Business Ideas for Students - Easy to Start Business Ideas for Students in India

Why is Business Valuation Necessary?

Business valuation is an important step in improving a company. Here are some reasons for performing a business valuation of a company.

1. Litigation

In a court case related to divorce, injury case or one with an issue regarding the valuation of the business, it might be necessary to provide proof of the worth of your business so that while calculating damages, it is based on actual worth rather than estimation of a lawyer.

2. Exit Strategy Planning 

Suppose you are planning to sell your business. In that case, preparing a base value for the entity is suggested and then creating a strategy to increase the company's profit so that your exit strategy has an increased valuation. A valuation which has annual updates will prepare the business for expected and unexpected sales. It will ensure that you are correctly informed with fair market value and help prevent loss of capital caused by inaccuracies or lack of clarity.

3. Buying a Business 

Buyers and sellers might have differences of opinion on the value of the business. The buyers only agree to pay the real business value. A good business valuation looks into potential income and market conditions and ensures that you make a viable investment. A business broker should be hired to be guided with the process.

4. Selling a Business

If you decide to sell your company or business to a third party, you should be certain that you receive its worth. The asking price has to be attractive for prospective purchasers and profitable for you.

5. Strategic Planning 

A depreciation schedule might not show the true value of assets, and it might be risky not to have any adjustments to the balance sheet in the case of various possible changes. When you have a current valuation of the company, you will be able to make informed decisions.

6. Funding 

You might need an objective valuation if you want to negotiate with the banks or any potential investors for raising funds. Professional documentation for your business’s worth is necessary as it can enhance credibility to your lenders.

7. Selling a Business Share 

Business owners need to go through proper business evaluation so that they know the worth of business shares and can readily sell them whenever required. During the sale of the company, you need to ensure that you receive a good value for your share.

Also Read: Business Ideas Under ₹50,000 - Which Businesses Can You Start Under ₹50,000

Methods of Business Valuation

If you want to know how to value a business, there are multiple methods listed below.

1. Market Capitalization

This is the simplest and most effective method of a company valuation. You can calculate it by multiplying the business’s share price by its total number of outstanding shares. A good business valuation example will be Microsoft- if Microsoft Inc. is traded at $86.35 with an outstanding share value of 7.715 billion, Microsoft’s valuation will be $86.35 x 7.715 billion=, $666.19 billion.

2.Times Revenue Method 

The times' revenue method of business valuation suggests a stream of revenue generated over a specific time period multiplied by a number determined by the condition of the industry and economic environment. While a tech company can be valued at 3x revenue, a service firm’s value can be at 0.5x revenue.

3. Earnings Multiplier

An earnings multiplier method can determine the real value of the business more accurately than the times' revenue method. This method depends on the company’s profits to determine financial success, as the sales revenue can not be accurate. This method adjusts future earnings against the current cash flow, which could be reinvested at the recent interest rate over the exact same time period. The earnings multiplier adjusts the P/E ratio to account for ongoing interest rates.

4. Discounted Cash Flow Method 

This business valuation method is identical to the earnings multiplier method. It is based on the projections of future cash flows, which are then adjusted to calculate the current market value of your business. The difference between both the DCF and profit multiplier method includes the consideration of inflation to determine the present value.

5. Book Value 

This refers to the shareholder’s business equity value as shown in the statement on the balance sheet. The book value can be calculated by subtracting the total liabilities from the total assets of a company.

6. Liquidation Value 

Liquidation value refers to the total cash to be received by a business if the assets are liquidated and liabilities are paid.

7. EBITDA 

Financial analysts don’t want to look at the raw net profitability of a business while examining earnings. It can be manipulated by distorting the true picture and via accounting conventions. For example, a country’s tax policies can disrupt a business entity's success and vary in different countries and time zones, although the company's operational capabilities might not change. On the other hand, net income can subtract interest payments from a debt holder, which makes the entity look more or less successful, judged by its capital structures. Therefore, both of these considerations make us arrive at EBIT or Earnings Before Interest and Taxes, also referred to as operating earnings.

When a business purchases a building or equipment, the transaction is not recorded all at once. The entity then charges itself a depreciation expense for a time period. The same kind of charge is deducted in the case of intellectual property and patents, and then it is called Amortization. In both cases, no money is spent. Amortisation and depreciation can make the earnings look worse in a certain way. Therefore, calculating earnings before interest, taxes, depreciation and Amortization for each company can help to explore ratios and determine a market value.

Other than these methods, business valuation methods include breakup value, replacement value, asset-based valuation etc.

Also Read: List of Best Low Cost Business Franchise In India

Conclusion:

A valuation process helps define a business entity's fair market value. Valuation might be required for business reorganisations, employee stock, shareholder disputes, takeovers, etc. This critical financial analysis helps business owners are able to strategise the business, plan an exit strategy, reduce financial risk at the time of litigation and acquire financing. Hopefully, you have understood the basics of business valuation

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FAQs

Q: What multiples are businesses selling for?

Ans:

Most businesses sell for approximately 2-6 times SDE(Seller’s Discretionary Earnings), and all businesses under $1 million have an average multiple SDE of 2.2 times in the last 10 years. However, the multiple is not always as much as the seller wants it to be. SDE’s are a ratio to calculate the historical cash flow of a business.

Q: How do you calculate the valuation of a business?

Ans:

The commonly used formula is that business value equals assets minus liabilities. The assets refer to everything that has a value which is convertible to cash, such as equipment, real estate or inventory.

Q: What are the 5 methods of valuation of a business?

Ans:

The 5 business valuation methods are Market Capitalization, Times Revenue Method, Earnings Multiplier, Discounted Cash Flow Method, Book Value etc.

Q: What is a rule of thumb for valuing a business?

Ans:

The most common rule of thumb is a percentage of the yearly sales or the last 12 months of revenues.

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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.