What Is a Business Valuation?
A business valuation is a report compiled by a valuation professional that determines by various means the economic value of a business or company. That value will be “the price that a reasonable person would pay to own the future cash flows of a business less any debt owed plus all cash on hand.” To create this report, the evaluator will use financial statements, cash flow models, and market analysis as well as taking into account the unique features of the business itself, including its management and human capital.
Business owners need a valuation done in a variety of situations. There are many reasons why a business’s value might need to be determined, including a divorce, shareholder disputes, a merger or acquisition, the liquidation of the business, or the drafting of a buy-sell agreement. If the company has any tax or legal issues to resolve, a valuation will need to be performed. If the company wishes to raise debt, the bank it applies to will want to know the value of the business. Of course, valuations are often done as a precursor to a sale too.
Why Does Valuation Matter
A business valuation is a starting point for action. There may be business owners who have valuations done on their businesses for the simple satisfaction of knowing how much they are worth. If that is the case, they are wasting what a valuation reveals: how strong or weak their companies are. An owner should know how much his business is worth because it’s a snapshot of the past and a vision for the future.
Two Methods of Business Valuation
Some people would assume that valuation is a numbers-based science, but in some ways it’s more of an art. If you hire three valuation professionals, they will all give you valuations that differ from each other. With this in mind, however, there are two very common valuation methods that professionals use to determine business value. They are:
The discounted cash flow method – Also referred to as DCF, the discounted cash flow method determines a company’s value by estimating its future cash flows and calculating what these would be worth would be in today’s money. The value of that money is discounted because it’s estimated and not actually earned yet. There are future variables that simply cannot be predicted. Once the present value of future cash flows is determined, any debt the business has currently is subtracted from that figure and any cash on hand is added to it to get the valuation.
The multiple market method – Using this method, the valuator doesn’t worry about projecting cash flows. Instead the valuator considers other comparable businesses in the same market and what they have sold for. Then a metric of the company, such as its revenue or earnings, is used to determine its value based on those sale prices. For example, if another similar business recently sold for $1 million and had $250,000 in earnings, the multiple would be the sale price divided by the earnings or 4. The valuator would then multiply the company’s earnings by 4 and then, as above, subtract any debts and add in any cash to determine the company’s value.
Both methods have their pros and cons. The discounted cash flow method calculates value based on past performance and estimated future performance, which is important but is also harder to predict the farther into the future you go. The multiple market approach takes into account what like business are selling for right now, but it’s less specific to the company being valued. Because of this, it’s useful to value using both methods and then weight them accordingly to come to the most accurate valuation.
Prometis Partners recommends that all companies, regardless of whether they are considering a sale, have an updated business valuation always. The information gathered in this type of report is useful in so many ways and will help an owner become aware of issues in the company that are standing in the way of it being optimally successful. Multiple valuations done over a period of years will chronicle a company’s history far better than most other metrics.
We are here to assist business owners make exit planning and the eventual transition and sale of a company as smooth and stress free as possible. Please call us if you have any questions about how to prepare your company and your family for the future.