There comes a time when you may need to determine the value of your business. Perhaps you want to sell the business or get funding to continue your ongoing projects and expansions. Some owners may also need a valuation to enhance their business’s strategic planning. Regardless of your reasons, understanding business valuation as a process is essential to navigating it with confidence and getting more accurate results.
What Influences the Value of a Business?
Before we delve into the methods used in valuations, it is important to first familiarise yourself with the factors that influence a business’s value. These are plenty – however, the top ones on the list include the following:
- Revenue flow – businesses with strong revenue flow tend to demand higher prices. Such businesses have great customer retention programs, ensuring recurring/repeat business.
- Profits – how much of the revenue collected is considered profit? If the profit margin is high, the business will have a higher value.
- Scale and efficiency of the business model – this has a lot to do with the ability of the business to grow without a proportional increase in the costs of running. Such a business will have a higher value.
Beyond these internal factors, there are additional external elements that have a huge effect on the value of your business. Examples of these factors include industry trends and economic conditions. But, these are often out of your control as an owner – so, you can only focus on improving the internal ones, which you have more control over.
Common Methods of Business Valuation
Asset-based Valuation
Asset-based valuation is a method that aims to determine the worth of your business by calculating the difference between the value of its assets and its liabilities. For instance, if the business has assets worth £50,000 and £10,000 in liabilities, the value will be £40,000 (£50,000 – £10,000).
Asset-based valuation is often used to estimate the worth of asset-heavy businesses like manufacturing plants. It is further split into 2 subcategories:
Net Asset Value
To get the net asset value, you subtract the total liabilities from the total assets recorded in the business’s balance sheet. Most people prefer this approach because it is easier to calculate. However, the figure you get may not represent the true market value of the assets as it only provides a snapshot of the company’s book value at a given time.
For business owners looking to grow, sell, or even open a business account online in the UK, understanding asset-based valuation is essential. It helps present a clearer financial picture to banks, investors, or lenders, particularly when applying for funding or establishing financial credibility.
Adjusted Asset value
Adjusted asset value is used to further refine the net asset value method by doing the calculations using the current market value of the assets. Unfortunately, this approach makes the valuation a little complex as you will need the help of a professional appraiser. Additionally, the market valuations of assets may be subjective, which may lead to incorrect valuation of the business.
Income-based Valuation
Income-based valuation involves the use of a business’s ability to generate future income to estimate its value. Essentially, it aims to, presently, calculate the value of future earnings – making it a suitable approach for businesses with predictable revenue flow.
This method is mostly used by businesses with intangible assets like customer loyalty and brand reputation. It is also sub-categorised into two:
Capitalised Earnings Method
This method estimates a business’s worth by dividing the projected annual earnings by a capitalisation rate. What this means is – it assumes the business will continue earning revenue at a stable rate (indefinitely). Unfortunately, that doesn’t account for potential growth and volatility. However, it is a simpler approach as you do not need to calculate a more detailed projection of future earnings.
Discounted Cash Flow
The discounted cash flow valuation approach also uses a projection of future cash flows to evaluate a business. However, it adds a little twist by using a discount rate (often the cost of capital) to discount them to present value. Most businesses use this approach because (unlike the capitalised earnings method) it accounts for future growth potential.
Market-based Valuation
Market-based valuation involves estimating the value of the business by comparing it to similar companies that have recently been evaluated/sold. This method relies heavily on market data rather than internal financials and other factors. That said, it is only useful for businesses that share market competitiveness and have very similar sales.
Comparable Company Analysis
This approach uses financial ratios, including P/S (Price-to-sales) and P/E (Price-to-earnings), as the basis for comparing the target business to the recently sold one.
Precedent Transaction Analysis
This market-based valuation method determines the valuation range by looking at past transactions of similar businesses. For that reason, it provides a true reflection of industry-specific demand and valuation trends, making it the perfect approach for owners interested in selling.
Tips for Choosing the Right Business Valuation Method
Selecting the right business valuation method is important because it not only increases the accuracy but also ensures you adhere to legal requirements. So, how do you select the right valuation method?
Define Your Business Type
Your business type has a significant influence on the method you will use for valuation. For instance, if you have a manufacturing or real estate business (asset-heavy businesses), asset-based valuation is a better choice compared to income-based valuation. Similarly, if your business operates with intangible assets (e.g. a service/technology-based company), income-based or market-based valuation will give the more correct value.
Purpose of Evaluation
In addition to business type, it is essential to also determine why you need the valuation. For instance, if you are determining the value intending to sell or merge, you should consider using market-based valuation (because it determines competitive price). Similarly, owners who are seeking investment should use income-based valuation because investors will want to see the potential for future returns.
Also, if the purpose of valuation is financial reporting or for taxes, you will need to use asset-based valuation as well.
Consider Earnings Stability
How stable are your earnings? Answering this question will also help you determine what will be the most ideal valuation method to use. For example, businesses that have steady and predictable profits can use capitalised earnings methods. Alternatively, they can use discounted cash flow if the business is new or growing fast.
For businesses with extreme fluctuations in their revenue flow, it might be better to use market-based valuation as it paints a better picture of what investors and buyers think the business is worth.
Conclusion
Accurate business valuation is essential for making informed decisions when it comes to selling, investing, securing investment and strategic planning. That said, you must ensure you are using the correct method based on factors like business type and purpose of valuation. You can also combine multiple methods to get a more accurate figure. If you need any help, do not be afraid to work with a professional business valuator.
