A business valuation is key for an acquisition, as going too high or too low can make or break a deal. Here are 7 ways to do a valuation.
A reliable business valuation is essential whether you're considering buying or selling a company, attracting investors, or negotiating a loan. However, with numerous valuation methods available, choosing the right one can feel overwhelming.
This article explains seven of the most common business valuation methods, diving into their core principles, strengths, and weaknesses. We'll also provide a helpful tool you can use to streamline the valuation and selling or buying business process.
Imagine buying a used car without knowing its market value. You might end up paying significantly more than it's worth. Business valuation operates similarly. It objectively assesses a company's financial health and future earning potential. This information empowers informed decision-making for all parties in scenarios like:
The choice of a valuation method depends on various factors, including the company's size, industry, financial data availability, and the purpose of the valuation. Here's a breakdown of seven methods you can use.
This method compares the subject company to similar businesses recently sold in the same industry. It analyzes factors like size, profitability, and growth potential.
Strengths: Easy to understand and implement if comparable companies exist.
Weaknesses: It relies on the availability of relevant market data and may not be suitable for unique businesses or niche industries, like ecommerce or SaaS.
This approach estimates the present value of the company's future cash flows. It considers factors like historical earnings, projected growth, and the discount rate (which reflects the risk associated with the business). There are two main variations within this approach:
Strengths: Considers the company's future earning potential, making it valuable for growing businesses.
Weaknesses: Requires accurate financial forecasting and selecting the appropriate discount rate. It can be complex and sensitive to assumptions about future performance.
This method values the business based on the fair market value of its assets, including tangible assets and intangible assets.
Strengths: Useful for companies with significant physical assets or strong intellectual property.
Weaknesses: May not fully capture the value of a company's earning potential or brand reputation.
This method uses industry-specific valuation multiples based on recent M&A deals in the same industry. Common multiples include Price-to-Earnings (P/E) ratio, Enterprise Value-to-EBITDA (EV/EBITDA) ratio, and Price-to-Sales (P/S) ratio.
Strengths: Relatively simple and quick to apply, especially if relevant industry data is readily available.
Weaknesses: It relies on the assumption that the subject company is similar to those used in the multiples calculation, which may not accurately reflect the business's unique circumstances.
This method assigns scores to various qualitative factors impacting the business value, such as management experience, market position, brand recognition, and customer base. These scores are then weighted and combined to arrive at a final valuation.
Strengths: Considers qualitative factors often overlooked in other methods.
Weaknesses: It is subjective and highly dependent on the chosen scoring criteria and assigned weights. It requires significant judgment from the appraiser.
This method estimates the value of a company by assuming its assets are sold off piecemeal. It's typically used for businesses in distress or considering shutting down.
Strengths: Useful for understanding the company's net asset value in a worst-case scenario.
Weaknesses: It may not reflect a business's value as a going concern, particularly if its value lies in its ongoing operations and future potential.
Many businesses employ a hybrid approach combining elements from several methods discussed above. This allows for a more comprehensive and nuanced valuation, considering both quantitative and qualitative factors.
Strengths:
The Rule of Thumb (ROT) gives a rough estimate based on easily available metrics like revenue or earnings. You apply a multiplier to a financial measure of the business, like annual sales, discretionary earnings (cash available to the owner), or EBITDA.
You might be thinking that it sounds familiar, as people often confuse this method with the transaction multiples method. Both of them are related concepts in business valuation, but they're not exactly the same.
The key differences are the specificity, as transaction multiples are based on real transactions, while rules of thumb are more generic; the accuracy, as transaction multiples can be more accurate for a specific company, while rules of thumb provide a starting point; and flexibility, as rules of thumb can be adjusted based on the company's unique characteristics, whereas transaction multiples are tied to past deals.
