Definition: Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect the sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes.
The field of business valuation encompasses a wide array of fields and methods. The tools and methods can vary between valuators, businesses and industries. Common approaches to business valuation include review of financial statements, discounting cash flow models, and similar company comparisons.
How to Value a Business?: How much your business is worth depends on many factors, from the current state of the economy through your business’s balance sheet. Let me say it up front, I do not believe that business owners should do their own business valuation. This is a lot like asking a mother how talented her child is. Neither the business owner nor the mother has the necessary distance to step back and answer the question objectively. So to ensure that you set and get the best price when you're selling a business, I recommend getting a business valuation done by a professional.
Different methods of corporate valuation (market relative valuation)
- Asset-based approaches: Basically these business valuation methods total up all the investments in the business. Asset-based business valuations can be done on a going concern or on a liquidation basis.
- A going concern asset-based approach lists the business net balance sheet value of its assets and subtracts the value of its liabilities.
- A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off.
- Earning value approaches: These business valuation methods are predicated on the idea that a business's true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning. With this approach, a valuator determines an expected level of cash flow for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of the rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
- Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.
- What might such capitalization rates be? : It is quite subjective. Well established businesses with a history of strong earnings and good market share might often trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalization rates, say 25% to 50%.
- Market value approaches: Market value approaches to business valuation attempt to establish the value of your business by comparing your business to similar businesses that have recently sold. Obviously, this method is only going to work well if there are a sufficient number of similar businesses to compare.
Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the most fair way to set a selling price.
Valuation of closely held company/Minority ownership (Small business valuation): In valuing a minority and non-controlling interest in a business, however, the valuation professional must consider the applicability of discounts that affect such interests.
- Discount for lack of control: The first discount that must be considered is the discount for lack of control, which in this instance is also a minority interest discount. Minority interest discounts are the inverse of control premiums
- Discount for lack of marketability: Another factor to be considered in valuing closely held companies is the marketability of an interest in such businesses. Marketability is defined as the ability to convert the business interest into cash quickly, with minimum transaction and administrative costs, and with a high degree of certainty as to the amount of net proceeds. There is usually a cost and a time lag associated with locating interested and capable buyers of interests in privately held companies, because there is no established market of readily available buyers and sellers. All other factors being equal, an interest in a publicly traded company is worth more because it is readily marketable. Conversely, an interest in a private-held company is worth less because no established market exists
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