A Guide to the Different Types of Business Valuation MethodsJanuary 17, 2020
In 2018, 10,312 businesses exchanged hands across the United States. That was a 4% uptick in acquisitions from 2017.
Various reasons might cause you to want to sell or buy a business. No matter the reason behind each transaction, the one constant is that each target firm needs to be valued to determine an attractive price.
There are various valuation methods you can use to quantify the worth of a company that you plan to acquire or sell. The main valuation approaches are classified as asset-based, market value-based, and earning value-based. Here is a closer look at some valuation approaches you can use.
1. Profit Multiplier
The changes that took effect in 2018 were The profit multiplier business valuation method capitalizes on the profit to earnings ratio (P/E ratio), to determine a firm’s worth by multiplying its profit. In this scenario, the price is the company’s value, while the earnings are the profits the business generates.
For example, assume that a company brings in $200,000 annually, and you want to use a multiple of 4 to arrive at its value. The price at which you can value the business will be $200,000 multiplied by four, which yields $800,000.
It goes without saying that the multiple you use has a significant impact on the valuation. The larger the business is, and the better the track record, the higher the multiple you will use.
Typically, small firms command a multiple of between three and four using pretax profit. If it is a high performing firm, then the multiplier can go up to five. For larger businesses, the P/E multiples range between seven and twelve with an exceptional firm garnering a higher multiple.
When evaluating a business using P/E multiples, you should account for the adjusted profit. Adjusted profit is where you take the owner’s salary into account to arrive at an accurate profit level for the firm. You don’t want to buy a company whose profitability dips once the owner exits, leaving you with a less valuable investment.
Another point to consider when using P/E multiples to value a firm is the average profit. By taking Earnings Before Interest and Tax (EBIT) into consideration, you can gauge a target firm’s actual profit position before debts or surplus cash balances alter it.
2. Going Concern
A going concern valuation method is an asset-based approach that assumes a business will continue operating and be profitable. The going-concern value, also known as the total value, differs from a liquidation concern due to the inclusion of intangible company assets.
Such assets include brand names, intellectual property, customer loyalty, and trademarks.
With a going concern, you assess the value of a firm by looking at its assets and subtracting the liabilities. The only difference is that you get to count the intangible assets as well.
3. Liquidation Value
Liquidation valuation is another asset-based approach that seeks to determine how much cash will be left over once all the assets are sold off and liabilities paid. By its nature, liquidation valuation does not treat a business as a viable one. Thus, the assessment won’t include any intangible assets.
When you appraise a firm using liquidation valuation, the assets end up fetching a lower value that doesn’t reflect market value. Liquidation valuation is, however, higher than salvage value. Since liquidation valuation is typically urgent, the seller’s focus is usually to get as much money in the shortest period possible.
Comparable business valuation is one where you look at similar businesses with similar metrics to estimate the value. These metrics can include Earnings Before Income, Taxes, Depreciation, and Amortization (EBITDA), price to book, price to earnings, and enterprise value to sales, among others.
To pull this off, you need to run a comparable company analysis (CCA) that helps paint at the best peer firms to look at.
“… similar metrics to estimate the value.”
When using comparables valuation, you should be wary of making inaccurate comparisons. Talk to others in your industry to have a better picture of what other firms are selling at so that you can better anchor your comparison metrics.
5. Discounted Cash Flow
Discounted cash flow valuation (DCF) appraises a firm based on its future cash flows. Essentially, DCF explores the current value of a business today based on what is predicted to earn in the future.
When you are using DCF, you need to consider the future profit margin and sales growth. In addition to these, you can’t avoid taking the discount rate into account. The discount rate is influenced by several factors that you must assess, including the following:
- The risk-free interest rate
- The cost of capital
- Potential share price risks
A DCF valuation model works best when you are assessing a firm you intend to control. You will have a much better ability to forecast factors that inform the valuation model.
To calculate a firm’s value, you need to forecast the revenue coming into the business and the expenses that will likely be paid out for several years. Once you have this information, you can then subtract the expenses from the revenue to ascertain the estimated net cash flow position for each year.
Apply a discount rate to the figure for each year’s net cash flow to figure out the net present value of each year’s future profit. Remember that you have to use an accurate discount rate, or else the results might be skewed.
Many people tend to use a three to five-year horizon when forecasting the revenues and expenses in a DCF model. If you expect the firm to continue generating income beyond the five years, then you need to consider the terminal value. Terminal value is that income generated by the company beyond the outer time limit of your DCF model’s time frame.
Get the Best Price Using the Right Valuation Methods
Business acquisitions are inevitable, and to get the best value, you need to understand how various valuation methods work. If you use an ill-fitting approach, you may not ascribe the best value to the business you want to sell or buy hence losing out on value.
The Curchin Group, LLC, has been helping businesses since 1955 meet their accounting needs. Talk to us today to find out how you can get the best value, whether you’re buying or selling a business.