What is Business Valuation?

Business valuation is the “act or process of determining the value of a business enterprise and the ownership interest therein”.

Why Value Your Business?

From small-to-medium enterprise start-ups to blue-chip companies listed in the stock exchange, valuation is an imperative financial tool.

At some point in the business, business owners and management teams will find themselves in the position needing a valuation. The need for a business valuation can range from personal reasons to corporate situations; from elective reasons to necessities in making a business decision.

To start with, business valuation allows business owners to know where their business stands in the current market, creating a baseline for measurement. With the baseline, entrepreneurs can then create financial goals, allowing business owners to quantify their progress, measure the business growth potential and most importantly, protect the business.

Essential business plannings, inclusive but not limited to insurance plannings, estate planning and succession planning are dependent on business valuation. Drafting of buy-sell agreements with partners, business fund-raising, strategizing for mergers acquisitions are situations where business valuation plays an integral role.

The Number

It is clear that business valuation is indispensable. The golden question would be, how do we arrive at THE number?

In fact, there is no one right number when it comes to business valuation, because a business is worth what a buyer is willing to pay for: willing buyer-willing seller basis. A seller basically plucks out a number that he is willing to let go the business for, justifying the number with certain valuation methods to convince the buyer. Even if the business is not a money-making business, you can still have a valuation method to give it a price!

Valuation Methods

There are over a hundred valuation methods that exist in the business world. But, there are a few common ones that we usually come across which we will discuss about.

1. Market Value Valuation

This is a subjective method involving comparing the company’s value to similar businesses that have been sold. Hence, this method can only be used if comprehensive data can be obtained of their competitors. There is a high possibility of miscalculation using this valuation method, thus it is usually used in situations where sellers are confident in the negotiation.

2. Asset-based Valuation

This method of valuation is determined by subtracting the company’s liabilities from the total net asset value. However, in situations where the company’s business is likely going to stop operating in the future, the method of calculation will be based on liquidation value asset-based valuation, which is the net cash the business owner will have at the point of business termination.

3. ROI-Based Valuation

This is a very useful valuation method especially from an Investor’s perspective. The valuation is determined by the return on investment that an investor is going to receive by purchasing or investing in the business. However, the ROI tends to fluctuate according to the market’s condition.

4. Discounted Cash Flow Valuation

Also known as Income Approach Valuation. In this method, the company’s value is calculated based on projected cash flow. It is especially useful if the company has a contracted revenue stream. The calculation is done by adding up the expected income to be received from the contracts during the contract term, which gives us a big number and some reduction is given as a risk discount.

5. Price-earnings (P/E) ratio

This is probably the most common valuation method because this is what the public-listed companies use to value their company. There are different types of P/E, e.g. trailing P/E which is based on past performance and forward P/E which is a prediction of how the company will do next year, which is subjective.

6. Barrier to Entry

This method of valuation is useful when the business is not making much money. It basically calculates how much it would cost if an investor/buyer were to start up a similar business to get to the position where the seller is, e.g. getting to having a database of 500 clients. It would then make the business attractive to buy as the buyer/investor would save the time and money to start afresh to gain the same achievement.

There are 3 factors that influence the valuation of a business: the “why”, the “how” and the “who”. The 6 valuation methods that we have just discussed are just the “how” of the valuation. The reason “why” a business is going for a valuation, which is the objective and purpose of the valuation may produce different results. Similarly, the person or firm “who” is performing the valuation may yield a different value based on their experience and their philosophy in valuation.

Business valuation is a complicated process, and it has to be done depending on the type and scale of the business. It may not be necessary to only use one method, but at times, combining a few methods may be needed to arrive at a more accurate “Number”.