How to calculate the value of a business is still an open question for many companies across diverse industries.
Business valuation helps venture investors and buyers define the target company’s financial worth and understand its value. Business valuation is pivotal during sales, investments, and planning.
Knowing how to value a business is a meticulous process that determines the fair market value of a business on sale or subject to strategic investment. Business valuation helps business owners prioritise key value factors and make informed management decisions to increase their company’s market value.
Beyond selling the company at a higher cost, business valuation delivers insights into strategic planning and business management.
How to value a business based on revenue? Business valuation analyses the company’s historical performance and appraises its revenue-generation potential, market standing, comparative advantages, and risks. The major valuation outcome is in its strategic decision-making.
Business valuation use cases:
- Mergers and acquisitions (M&As) deploy professional valuation as a strategic foundation for further negotiations with potential buyers. The better the M&A sell-side understands its company’s value, the more value deals it will engage in. The deeper the business valuation analysis of the target company, the greater the prospects of raising its market value. That’s the simplest business valuation formula.
- Business exit planning is a long-standing planning and implementation of value-enhancement strategies to prepare one’s business for an anticipated exit. Regular valuations help businesses track their performance and adjust their exit strategy. Owing to early valuations, business owners set realistic expectations, timelines, and milestones to prevent hectic decisions during transition.
- Spotting areas for improvement helps business owners generate long-term value for their companies by comparing their valuation metrics against industry benchmarks to leverage comparative advantages and focus on weaknesses.
Why Business Valuation Is Not One-Size-Fits-All
Different businesses and industries require different business valuation approaches. The right answer to the question of how to value a company will depend on
- Business type
- Company size
- Growth stage
- Market conditions
- Profitability.
Diving deeper into the company’s real worth is always a strategic decision to ensure a potential sale, attract potential investors, or pursue strategic planning.
| Business valuation approach | Short description |
|---|---|
| Earnings-based valuation | The method appraises the target company’s future profitability and applies to seasoned market players with predictable cash flows. |
| Discounted cash flow (DCF) | The method helps to project cash flows compared to their present value, considering financial fluctuations and business risk. |
| Market-based valuation | The method compares the target company to similar recently sold businesses. The approach best suits mature industries featuring ample market data regarding comparable transactions. Market-based valuation provides a realistic business appraisal and its sales price based on the real-market benchmarks and trends. |
| Earnings multiples | The method values the target company based on industry benchmarks to define the multiple of its annual profit. The earnings multiples approach emphasises the target company’s revenue-generation potential, crucial to heat the buyer’s interest. |
| Asset-based valuation | The method appraises the target company’s value by calculating its assets without liabilities. The approach encompasses tangibles and intangibles to establish a floor” value. The companies that heavily rely on intangible assets should opt for an alternative business valuation approach. |
- In earnings-based methods, valuation outcomes and business growth projections depend on industry trends, economic fluctuations, and operational suggestions. Startups and early-stage businesses are risky and necessitate a detailed comprehension of market dynamics.
- The market-based approach may cause misleading valuations in the case of unpredictable market fluctuations caused by economic downturns or industry disruptions.
- Intangible assets depend on assumed benefits in the future, and so it is rather difficult to define their values.
Clients often ask us how to value a small business. Depending on your business size, we recommend a mix of the following valuation approaches:
Overview of the 3 Main Valuation Approaches
Income approach
The income approach (also referred to as the DCF method) accounts for other companies’ performance indicators. The approach forecasts the projected cash flow for a mid-term perspective from three to five years.
The approach grounds itself on the current value compared to the projected earnings in the future to forecast investors’ interest. The method embraces a discount rate to compare the target company’s present value to the investment amount.
Discounted cash flow (DCF)
Discounted Cash Flow (DCF) estimates the investment value based on the future cash flows. This company valuation approach helps businesses forecast capitalization growth based on inflation and the cost of capital.
A business projects how much money an investment will bring in over a given time frame to compute DCF. A discount rate, usually the company’s weighted average cost of capital (WACC), is then used to “discount” future cash flows back to their present value.
The average rate of return that a business anticipates paying to each of its capital providers is reflected in its WACC. The intrinsic value of the investment is determined by adding the terminal value, which represents the value of cash flows that occur after the forecast period, to the present value of these future cash flows. Generally speaking, the investment is deemed worthwhile if the intrinsic value surpasses the current cost.
Businesses or projects with distinct and predictable future cash flows are best valued using the DCF method. It is especially helpful for expanding businesses whose earnings may be low now but are expected to generate large sums of money in the future.
Companies use DCF to:
- Carry out thorough investment evaluations
- Think about purchasing
- Carry out internal capital budgeting
- Put long-term projects into action.
However, because forecasting becomes extremely speculative in these situations, it is less appropriate for businesses that are volatile or lack a clear cash flow history. Essentially, DCF will offer a strong intrinsic value if future cash flows can be accurately projected.
When evaluating projects or well-established companies with steady future cash flows, DCF works best. In addition to helping investors ascertain the inherent value of a business or asset, it is perfect for evaluating possible acquisitions and important capital expenditure choices.
Other valuation techniques might be more suitable for very early-stage start-ups without a distinct revenue history or in situations where cash flows are extremely erratic or unpredictable. DCF offers a comprehensive perspective of future profitability and is a powerful tool for evaluating long-term investments.
Capitalisation of earnings
The capitalisation of earnings valuation technique determines a company’s value by converting its projected future earnings into a single present value. This strategy works best for well-established companies with a history of consistent and predictable profits because it assumes that earnings will stay the same for the foreseeable future.
Addressing the question of how to evaluate a business, the fundamental concept is to use a representative number for the business’s “future maintainable earnings”, which is usually an adjusted average of previous profits, except for one-off items. A capitalisation rate is the investment’s risk and anticipated return on investment from future assets.
A simplified form of discounted cash flow is capitalisation of earnings, wherein the present value is calculated by capitalising a single sustainable earnings figure rather than a comprehensive cash flow forecast. The investment might be deemed appealing if the final value exceeds the acquisition cost.
Pros and cons of the income approach
Pros:
- Is perfect for stable, expanding businesses because, like DCF, it accurately predicts a company’s future earning potential.
- It is adaptable, taking into account different situations and presumptions.
- Connects value directly to a company’s potential for future profits while using discounting to account for growth and risk. It offers a thorough, forward-looking analysis and is theoretically sound for going concerns.
Cons:
- It is complicated and possibly subjective, though, as it is extremely sensitive to forecast accuracy and the discount rate; even small changes in input can have a big impact on valuation.
Market approach
The market approach, also referred to as the multiples method, compares similar companies that are worth similar value. The business valuation approach is best suited for well-established industries, where companies can compare their value to that of similar companies that have been recently sold.
Comparable company analysis (Comps)
Comparable company analysis (Comps) compares a company’s financial metrics to those of other publicly traded companies in the same industry to determine how valuable the company is. The premise is that companies with comparable attributes (size, growth, profitability, etc.) and in the same industry ought to have comparable valuation multiples.
How to calculate business value? Analysts calculate key valuation multiples, like price/earnings or enterprise value/earnings before interest, taxes, depreciation, and amortisation (EBITDA), after identifying a peer group of comparable businesses.
Precedent transactions
A valuation methodology known as precedent transactions looks at the prices paid for comparable companies in previous acquisition deals to ascertain a company’s value. The control premium, an extra sum an acquirer usually pays to take over a business, is considered in precedent transactions. This is not the case in comparable company analysis, which makes use of publicly traded multiples.
Analysts look at recently concluded M&A deals involving targets with comparable financial size and industry traits. To estimate the target company’s possible acquisition value, they compute the valuation multiples (such as Enterprise Value/EBITDA and Price/Earnings) from these prior transactions and apply them to the financial metrics of the target company. Because it reflects the real market demand for comparable assets, this approach offers a reasonable standard for M&A negotiations.
Pros and cons of the market approach
Pros:
- Based on actual market data, it offers an unbiased assessment of current investor sentiment and market trends.
- Widely accepted, as it is comparatively easy and quick to apply when similar businesses or transactions exist.
Cons:
- Finding genuinely comparable companies can be challenging, particularly for unique or private businesses.
- A company’s unique competitive advantages or potential for future growth may not be sufficiently reflected by market fluctuations, which could result in erroneous valuations.
Asset-based approach
The asset-based approach subtracts all of the liabilities and adds up the fair market values of all the tangibles and intangibles. It’s particularly useful for liquidation situations, asset-heavy industries like manufacturing, and start-ups with no history of earnings.
Businesses use it to set a “floor” valuation so they know how much the underlying asset is worth. It may, however, undervalue companies that have substantial intangible assets that cannot be measured or that have promising future growth prospects that are not yet shown on the balance sheet.
Book value vs liquidation value
The net worth of a business on the balance sheet is reflected as the book value. Usually based on past expenses and accounting concepts like depreciation, it is computed as total assets less total liabilities. In theory, book value is the amount that shareholders would receive if debts were paid off and assets were sold for their recorded value.
Liquidation value, on the other hand, is the approximate amount of money that a business would make if its assets were sold off quickly, which is often the case during difficult times (like bankruptcy). It is usually less than book value because intangible assets (like goodwill or brand) are usually not included and assets are sold at a discount in a forced sale.
In the event of a company closure, the liquidation value is the bare minimum amount that creditors and shareholders can get back.
When is the asset-based approach most effective?
For businesses that primarily derive their value from their tangible assets, like manufacturing or real estate, are known as asset-heavy businesses, because these assets fairly represent their underlying value.
Distressed sales/liquidation: to determine a value for a company that is going through financial difficulties or dissolution by estimating the “floor” value that could be recovered from the sale of assets.
No consistent earnings: when valuing a business based on future income is impractical, it is appropriate for start-ups or companies with no consistent earnings history.
Pros and cons of the asset-based approach
Pros:
- Offers a precise, observable valuation based on physical assets, making it perfect for liquidations or businesses with lots of assets.
- It is less dependent on assumptions about future earnings and provides a “floor” value.
Cons:
- Companies with strong intangible assets (patents or brands) or strong growth potential may be greatly undervalued.
- Fails to represent a business’s future profitability or going-concern value, necessitating a thorough reassessment of assets.
Regardless of the chosen business valuation approach, using a virtual data room will soothe the M&A process securely and avoid risks.
Compare top VDR providers to make informed investment decisions
How to Choose the Right Business Valuation Method
A combination of business valuation methods is usually used in effective business valuation to produce a thorough and reliable evaluation. The income approach, which mainly uses discounted cash flow (DCF), is best suited for well-established and expanding businesses since it calculates value using anticipated future earnings.
By using market multiples from comparable companies and previous transactions, the market approach, including comparable company analysis (Comps) and precedent transactions, offers an external viewpoint that reflects the mood of the moment.
Last but not least, the asset-based approach determines a “floor” value by evaluating net tangible assets; this method is especially helpful for companies with lots of assets or in liquidation situations. By combining these techniques, individual limitations are lessened and a more comprehensive and trustworthy valuation is produced.
Business valuation as an art and a science
Because it depends on established methodologies (DCF, multiples), data analysis, and financial models, valuation is a science.
Forecasting, choosing comparables, calculating discount rates, and analysing qualitative elements like competitive environments and market sentiment all require subjective assessments, which makes it an art.
Use cases
The market approach is frequently crucial for a SaaS startup. Revenue multiples, particularly ARR or MRR multiples, from similar SaaS companies are crucial given low or nonexistent profitability. Because traditional profit-based valuations are less relevant, investors use metrics like recurring revenue, growth rate, customer churn, and LTV: CAC ratio to evaluate future potential.
Because manufacturing companies have a lot of equipment and inventory, it is usually best to combine the asset-based approach with the income approach (more especially, EBITDA multiples or DCF).
While the income approach captures operational efficiency and future earning power—both of which are crucial for a continuing concern—the asset-based method offers a concrete “floor” value. A helpful cross-reference is also offered by market multiples from similar manufacturing companies.
Conclusion
There is no one “best” way to value a business; rather, the best strategy depends on the particular situation. The best option is determined by multiple factors, including the industry the company operates in, its stage of development (startup vs. mature), asset intensity, earnings stability, and the valuation’s goal (e.g., sale, fundraising, tax).