What is Business Valuation, and Why is it Important?

business valuation

Key Takeaways:

  • When planning for an exit, it’s critical to start with an accurate assessment of your company’s current value to understand how much you need to grow.
  • There are many ways to value a business, but all pretty much come down to earnings, growth, and risk.
  • Understanding how you’d like to transition and when is critical to identifying your current value and your future value gap.

Many business owners wish to sell their company at the highest price possible, but it is challenging to value their company. The company’s valuation can either make or break the seller’s decision to go to market. This is similar to selling a house; owners always believe that their house will sell for much more than it does. The emotional bond that homeowners have for their homes distorts their ability to propose a realistic price.

Similarly, business owners have a tough time ascribing market value to their lifelong projects. While some business owners willingly accept a low company valuation, others choose to enhance value before going to market to increase the potential selling price. Setting an inflection point and working towards this goal is essential for business owners to avoid settling for a lower than the ideal sales price. That said, before setting this inflection point, it is necessary to understand your business’s current value through a proper valuation.

What is Business Valuation?

Business valuation is a set of specific procedures and processes that helps both the buyer and the seller know the business’s worth. It may sound straightforward enough, but the devil is in the essential details. Whether a company seller or a prospective buyer, a credible valuation will require preparation, knowledge, and thought.

Different viewpoints will measure and identify value in a business differently. One interesting thing to note; the market is never constant; the conditions are continually changing. As the fortune of a particular company shifts, buyers will see more excellent value in acquiring it.

How the company is marketed to potential investors is the final test of a company’s business value. For example, a business presented to strategic investors will have a higher selling price than a nominal buyer.

The next question you may be asking – “Is the expected selling price and business value the same?”

In theory, the reason to establish the value of a business is to estimate what the owner can expect from a sale. A business’s value is determined by “who” wants to know the value and why in the real world.

For example, a goal-oriented business buyer looking for a way to replace his income may be willing to pay a premium price to acquire his dream business. In contrast, seasoned financial buyers are known for their low-cost acquisition game.

Another factor to consider is the market exposure that the business gets. It is vital to position your business in front of the right buyers to fetch the top price.

Let’s understand a few basics of Business Valuation:

The business unit’s total economic value determines a company’s valuation, which also considers the investor agreements on the company’s worth.

The process of business valuation relies on two elements;

Standard of Value – value that is used to establish a business’s worth, and

The Premise of Value – the company’s value depends on the situation under which the valuation is done.

Simply put, when we define business value, we establish a standard measure of deal that will determine a business’s worth. Different standards of value also lead to different conclusions about a business’s worth. For example, suppose an investor is solely focused on their financial gains. In that case, they will see a business’s value much differently than a budding entrepreneur concentrating on fulfilling his personal goals.

There are many standards of value used in Business Valuation, the most popular being:

  1. Fair Market Value – Whenever an asset is transferred, the buyer’s monetary amount offered and accepted by the seller is referred to as fair market value.

The value of the asset is established between a willing buyer and a willing seller. Both the parties are well aware of all the facts and are not coerced to conclude the sale transaction under pressure or unfavorable circumstances.

2. Investment Value – This value measure is used to determine a business’s value for a particular buyer or business investor.

When it comes to running or owning a business, different people have different goals. They may also perceive associated business ownership risks differently. Such differences have an impact on what people believe is a company’s actual worth. The investment value helps determine the value of a business for an investor or a buyer with specific business ownership objectives.

3. Intrinsic Value – This measure of business value reflects an investor’s in-depth understanding and knowledge of an asset or a company’s true long-term economic potential.

A potential buyer chooses this standard of value (to determine a business’s worth) only when they thoroughly understand all the fundamental attributes that constitute the business. Their solid knowledge helps them develop a comprehensive estimate that is dependent on what benefits they can/will reap from the company. The potential benefits can be summed as:

  • The potential business earnings
  • Future business growth
  • The business’s operational blueprint and financial strength.

To get an accurate business valuation, several factors have to be taken into account, these are:

  • The history and nature of the business
  • The overall economic outlook, considering the industries that impact it
  • The business’s overall financial condition, its book value, and overall earning capacity
  • The business’s history, in offering dividends and distributions
  • The risk to the investor if they invest in your business and industry
  • The industry of the company and overall experience in the industry
  • What will be the value of the business in case the owner is absent?

It is a necessity to thoroughly review and analyze the company’s financial history, its financial projections, the compensation offered to the executives, buy-sell agreements, the quality of its employees, organizational charts, the management team, the market competition, and existing customer base and the overall viability of the business in the absence of the current owner.

How Professionals Value a Business

Calculate Adjusted Earnings

Professionals value a business by analyzing three variables: earnings, growth, and risk. Analysts adjust the profit and loss statement to properly value a company’s earnings to account for one-time expenses, discretionary expenses, and other non-cash expenses.

Standard adjustments are made to adjust the owner’s salary to typical market rates, remove one-time expenses, and remove personal expenses from the profit-and-loss statement.

This is a crucial step in valuation, as analysts often use fair market value as the standard of value, which values a business for the hypothetical buyer. Essentially, adjustments are made to normalize the profit and loss statement to show a company’s actual earnings.

The Balance Sheet

A company’s balance sheet — a snapshot in time of what a company owns and what a company owes — is an essential indicator of its health.

In valuation, properly analyzing a company’s current assets and current liabilities is essential to determine the optimal working capital the company needs for operations. Analysts can also determine the capital structure of a business by looking at its debt and equity.

Additionally, similar to adjusting the profit and loss, entries on the balance sheet can be removed or reclassified based on whether they’re considered personal or non-operating.

Understanding Valuation Methods

Professionals rely on one of three valuation approaches to value a business; the market, income, or asset.

The market approach compares a business to similar other transactions or public companies in the marketplace. In doing so, analysts derive a multiple and apply it to the corresponding financial metric, such as revenue or EBITDA.

The income approach values a business by cash flow as a basis for value. In doing so, cash flow is either capitalized or projected into the future and discounted appropriately to conclude value.

The asset approach values a business based upon the book value of equity or the adjusted book value of equity. Analysts typically don’t rely on the asset approach, as the approach doesn’t consider the business’s earnings.

Analysts may choose to use a single approach or a combination of the approaches to value a company.

Factors Professionals Consider when Valuing a Business

As stated, professionals value a business based on three variables: earnings, growth, and risk. Analysts weigh the degree of these three factors conjoined to assess how much a company is worth.

All valuation cases are different, and there is no “one-size-fits-all” rule for what factors we consider most important. That being said, here are three factors that come up in just about every valuation case that I work on.

1. Margins & Profits

Margins or profits, the difference between revenue and cost, is a principal metric when you value a business. A business can improve its margins with efficient processes and operations. To do this, they may have to reduce overhead, lay off unnecessary employees, and invest in processes, equipment, training, etc.

Owners who plan to sell their business must ensure a positive trend of improved margins over the years and not just a one-time tactic to make their business seem more attractive to potential buyers.

2. Owner’s Influence

There is no doubt that a business owner is integral to operations, strategy, and success. The issue, however, is when the owner of that business is too integral. This is what professionals consider “key person risk.”

When we’re discussing a business’s outlook with its owner, we always ask the question, “What would happen if you were to get hit by a bus tomorrow? How would the business be impacted? Could the business succeed” Okay, sometimes we phrase the question more delicately, but the point remains the same? There is some serious risk if the business owner cannot adequately articulate that the business can succeed without them.

It is essential to delegate and develop a solid executive team. Buyers actively seek opportunities where the executive team is formed and ready to continue the grind of success post-acquisition. Not to mention that having a solid management team frees up the owner to grow the business.

3. Future Outlook & Growth

All valuations are done on a predetermined “as of” date. This means that our analysis only includes factors known at or before that point. However, that doesn’t mean we ignore the future outlook of a company.

A discounted cash flow analysis, a valuation method using the Income Approach, values a company based entirely on projected earnings.

Is the industry expanding or declining? Is top-line growth shrinking or continuing to grow exponentially? Is growth sustainable? These questions, among others, are those that we consider in our analysis of a business.

A business whose future is promising, defended by sound reasoning and historical performance, is a factor that can improve value drastically. On the contrary, a bleak outlook on the future may impede value.

Closing Thoughts

Business valuation relies on a thorough assessment of intangible and tangible factors. If you’re thinking about an exit, getting your business properly valued is a critical first step in understanding how much you need to grow to exit.

Getting a business valuation ensures you won’t be surprised when it comes time to sell your business. With Value Scout, you get an analyst’s take on your business’s current value. A few conversations with your wealth manager should give you a sense of how much you need your business to be worth to retire. From there, you can use Value Scout to close the gap between the two.

To gain deeper insight on valuation, check out our Valuation Course within the Guidon community.

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Matt Lawver

Matt Lawver

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