What is a Business Valuation?

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Definition:

A business valuation is a way of determining the financial worth of a company, often for the purpose of figuring out its sale value.

🤔 Understanding business valuations

When a company prepares to enter into a merger or acquisition, analysts use a business valuation to figure out what the company is worth. A business valuation may also be necessary if a company is preparing to take on more debt or sell more shares — In which case investors may want a detailed picture of the company’s financial situation. There are several methods used to value a business. One is market capitalization, which is a way of figuring out the value of a company’s outstanding stock (meaning the number of shares currently held by shareholders). Another is the discounted cash flow method, which is based on a projection of a company’s future cash flows. Business owners don’t generally perform these valuations themselves, but instead hire third-party professionals.

Example

Suppose the fictional fast-food restaurant, Burger Shack, was planning to acquire another fictional restaurant, Sandwich House. Before closing the deal, the two companies figure out how much Burger Shack will pay for the acquisition. This often requires conducting a business valuation of Sandwich House to figure out how much the company is worth. The companies usually agree together on a method. There are several methods the companies could use for the business valuation, and each might result in a slightly different number. The two companies decide to use the market capitalization method — So they take the total number of outstanding shares of Sandwich House and multiply the number by the current market value of one share.

Takeaway

Business valuation is like stepping on a scale to weigh yourself…

When you visit the doctor’s office, the nurse will often ask you to step on the scale before your appointment to see how much you weigh. The doctor may use that information to make informed recommendations regarding your health. Similarly, a firm might use a business valuation to evaluate their financial health. A firm might use different metrics to measure its worth, depending on the business valuation method and its purpose.

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What is a business valuation?

A business valuation is a way of figuring out the economic worth of a company. There are several methods a company might use for a company valuation, and it’s worth noting that figuring out business value can be a subjective process. While some methods use only concrete data (such as the company’s current assets and liabilities), others rely on estimates and projections. Each method is likely to produce a different result.

What is the purpose of a valuation?

There are many reasons a company might choose to get a valuation. For example, a company might choose to get a valuation when it’s about to enter a merger or acquisition. A firm might also need to know the value of your business if it wants to take on more debt or sell equity, as lenders and investors want to make sure the firm holds actual economic worth.

What are the methods of valuation?

There isn’t one correct way to perform a business valuation. There are many methods that one might use. Here are a few of the most common ones:

  • Market capitalization is a method of valuing a company by multiplying the total number of outstanding stock shares (meaning the number currently held by shareholders) by the current market price of a single share.
  • Fair market value is a way of assigning value to a company based on the purchase price of similar businesses. In other words, it’s the price that other comparable companies are selling for on the market.
  • Discounted cash flow is a method of valuing a company based on projections of its future cash flows (aka money flowing into and out of the company). This method includes an adjustment for the time value of money, which assumes that a certain amount of money today is worth more than the same amount of money in the future (as a result of inflation).
  • Book value is a way to assign value to a company based on its balance sheet. The book value is the difference between a company’s assets (except intangible assets such as reputation or trademarks) and its liabilities.

What is the valuation process?

Each business valuation process can vary depending on why it’s needed and who’s conducting it. But generally speaking, a business valuation often includes the following steps, based on information shared by appraisal firms:

  1. Get to know the business. For a company to effectively perform a business valuation, it first needs to have an in-depth understanding of the business, its structure, and ownership interest.
  2. Perform a financial analysis. A business valuation often requires a thorough analysis of what’s going on with a company’s finances — Just as a home inspector might do before assigning an appraisal value to a home.
  3. Decide on a business valuation method. Not all business valuations look the same. If a company hired a third party to perform the valuation, the analyst may suggest several methods of determining the company’s value. It’s usually up to the company getting the valuation to decide which method is right for them.
  4. Perform the business valuation. Once the method is agreed upon, the company performing the valuation will crunch the numbers based on the company’s books.
  5. Present the final numbers in a report. Once the third-party professionals have completed their valuation, they’ll present them to the company’s leadership in a report. They’ll be able to use this report when talking with potential investors or buyers.

How do you calculate the value of a company?

Calculating the value of a company looks a bit different depending on the business valuation method. Here are a few examples of common methods:

Market capitalization

Market capitalization is a valuation method available to established public companies. To find the market capitalization value of a particular company, you need two pieces of information: the total shares of the company’s stock (which is usually reported on its balance sheet), and the current market value of one share.

Suppose that a clothing manufacturer has 100 outstanding shares of stock that are selling on the market for $25 each. To find the market capitalization, you’d multiply those numbers. The formula looks like this:

100 shares x $25 per share = a market capitalization of $2,500

Fair market value

To find the fair market value of a company, you’d need to compare it to others on the market that have recently sold. Let’s say you own a local restaurant that you’re looking to sell. To estimate how much your restaurant could sell for based on fair market value, you’d look at the recent purchase prices of restaurants that are comparable to yours. You’d likely look for a restaurant with similar characteristics such as revenue, expenses, assets, and liabilities.

Discounted cash flow

When you calculate the discounted cash flow of a business, you need two primary pieces of information: the projected cash flow of a particular number of future years, and a discount rate. A company’s discount rate is based on the cost of capital (meaning the return a company needs to get for the investment to be worthwhile in the eyes of the investor).

The formula to figure out discounted cash flow looks like this:

DCF = (CF1/(1+k)^1) + (CF2/(1+k)^1) + (CF3/(1+k)^1), and so on

In this calculation:

  • DCF represents the value of the company based on the discounted cash flow
  • CF represents the cash flow
  • K represents the discount rate
  • Each extra repetition of the formula represents one more year

The cash flow in this formula is the expected cash flow for the company in the future. The discount rate helps to find what those future cash flows are worth when you account for the time value of money. The company will run this formula for several years to see what the expected value of the company is over time.

Book value

The book value of a company is the difference between its tangible assets (meaning a physical item such as a piece of property, equipment, inventory, etc.) and its liabilities. Companies usually report their assets and liabilities on their balance sheet.

Imagine a bicycle manufacturer has $100,000 in business assets, including the bikes it has in stock and the machines it uses to make the bikes. It also owes about $50,000 to lenders. It has some intangible assets as well, such as an excellent reputation and a trademark on its bicycle design, but those don’t count toward the book value. The calculation to find the book value would look like this:

$100,000 of tangible assets - $50,000 of liabilities = a book value of $50,000

What are business valuation services?

Like many of the services that companies need in the course of doing business, a business valuation is a service that companies often outsource. Companies may pay an appraisal firm to perform a business valuation in order to attract or inform potential buyers, investors, and lenders.

These services may be more or less comprehensive depending on the complexity of the company. Business valuations are often conducted by Certified Public Accountants (CPAs), which are accountants that have met specific education and license requirements, or other similarly qualified financial professionals.

Let’s say you’re planning to sell your company and want to perform a business valuation to see how much you might be able to get for it. Even if you had an accountant on staff, you’d likely hire a third-party firm to handle the valuation. This would add some credibility to the results when it comes time to show those numbers to buyers and is one of the primary reasons why companies hire a third-party service.

How much should a business valuation cost?

The cost of a business valuation can vary widely depending on the company and situation. Based on prices reported from several different companies that offer business valuation services, the cost generally falls anywhere between $2,000 and $35,000. Factors that may impact the price include the following:

  • Size of the company
  • Complexity of the business’s finances
  • Industry in which the business operates
  • Ownership structure
  • Age of the business
  • Condition of the records
  • Volatility of the business and the industry its in
  • Method of valuation
  • Purpose of the valuation

One important factor when it comes to pricing a business valuation is the purpose for which you need it. For example, an informal valuation for future reference may generally cost less than a comprehensive valuation for an acquisition.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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