Some argue that true value of a business is the amount that an investor is willing to pay. But this is not always the case. At least not when buying financial assets for the cash flow you expect to receive from it. Again, the perception of value has to be supported by reality. Meaning, the price you pay for any asset should reflect the cash flow it’s expected to generate. This general rule will help to make a good business valuation.
Of course, there are different aspects of valuation where people agree to disagree, like in estimating true value or the time it’ll take for prices to adjust to that true value. However, there’s one thing that can’t be disagreed upon. Asset prices can’t be justified by arguing that some other investor will be willing to pay more later on.
Knowing the worth of your business and what determines that value is the basis of intelligent decision making. Business valuation allows business owners, potential buyers and investors to know the economic value of a business for the following reasons:
- Buy and sell agreements – to set a value that’s mutually agreed upon by parties in a buy and sell agreement.
- Exit strategy planning – helps you set the baseline value when planning to sell your business.
- Partnership or shareholder disputes – helps you arrive at a fair settlement in case one party decides to leave the partnership.
- Funding – help raise capital when negotiating with potential investors.
- Litigation support – helps to strengthen your case when the business value is a problem.
- Divorce – helps determine a fair market value of the business interest for an equal division of assets.
- Tax planning – gives you precise, defensible and documented value to help you avoid conflicts with the IRS.
- Mergers and acquisitions – helps determine whether you are paying a fair price in case you are buying or merging with another firm.
How to value your business
There are numerous ways to value a business. Each approach has its own considerations. Here are some ways to make a good business valuation.
Market value approach
Market value approach tries to determine the value of your business by comparing it to similar businesses that have sold recently. It is more or less the same idea as using real estate comps to value a home. But it is only effective when you have sufficient market data on the similar businesses. The market value method, can therefore, be challenging for sole proprietors because of how hard it is for them to find comparative information on sale of similar businesses. But still, it is a great way to gauge the value of your business straight away.
An income approach allows you to figure out the kind of money the company is likely to bring. It also assesses the risk. Its real power lies in the fact that it lets you determine the business value in the present. But you’ll have to translate the expected income and risk to today using one of these translation methods:
- Income capitalization: you get this value by dividing the expected business earnings by capitalization rate (CR). So, if the CR is 22%, the company is worth about 3 times its yearly earnings. Capitalization of earning is suitable for business with steady, predictable earnings.
- Discounted Cash Flows (DCF) – DCF approach values a business based on future cash flows, discounted or adjusted to its present value. It gives you a much better view of your business’s real worth. The discounted cash flow approach can be especially useful if your profits are projected to change in the future. You can base your calculations of future revenue on a simple growth forecast or consider aspects like competition, volume, customer base and price.
You can also use the standard formulas to calculate the future cash flow and discount it to the present value. For example, if you expect the business to still be operational, you’ll have some residual value referred to as the terminal value. Discounting the terminal value and future earnings together gives you the present business value.
This valuation technique uses asset-based valuation to determine the value of your business. As the name suggests, asset-based approach focuses on business’s net asset value. The net asset value of your business is the total market value of all its assets, including cars, equipment, machinery, properties and computers. You must deduct the value of any liabilities, including debts, leases, finance or other equipment or money owed. There are two approaches to asset-based valuations:
- Going concern: This approach assumes that your business continues to operate and that no asset is sold. It looks at your business’s balance sheet, lists the company’s total assets and deducts its total liabilities.
- Liquidation value: This approach assumes that all assets are liquidated following closure. It determines the net cash or liquidation value that you’d get if you sold all your assets and paid off all liabilities.
Valuation by stock price
You can easily come up with the market value of a company that’s publicly traded by using the stock price. For example, if the company has a million publicly traded shares, and it is currently selling each share at $50, you’ll know that it’s worth is $50 million. Of course, using the share price alone to gauge value may not be as accurate because it’s only a perceived value.
Getting a good business valuation
Have a solid business plan – having your business plan handy is an effective way of showing your potential buyers and investors that you have a grasp of everything. It can also provide crucial information throughout the valuation process.
Put your finances in order – no buyer will want to buy a business with poor cash flow records. You’ll also have a hard time getting accurate valuation when finances are not in order. Some examples of documents you want to keep handy include financial statements, tax filings, credit reports, deeds, licenses and premises documents etc.
Get professional help – Unless you are really good at this, you may want to hire a business broker or any specialist to help with the process. Working with an experienced business broker ensures that you get the valuation done right the first time. Contact a professional business broker from BuyOrSellBusiness. We are able to help you with everything you need from the sale of your business!
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