What Is a Business Valuation?
A business valuation estimates the monetary worth of an enterprise. This value is crucial for various purposes, including financial reporting, dividing shareholdings, selling all or part of the business, creating succession plans, or securing financing. While it’s wise to understand how to value your business, it’s often best to enlist a professional for an accurate assessment.
It’s important to note that a business valuation doesn’t necessarily establish a selling price. It may play a role in negotiations, but the final selling price depends on various factors, including demand, market conditions, competition, intangible assets, and future prospects.
How to Value a Business: 6 Methods
1. Book Valuation
The book value is calculated by examining your balance sheet. It uses the formula:
Value = Assets – Liabilities
Essentially, it’s everything the business owns minus everything it owes. Assets include things like land, buildings, inventory, vehicles, equipment, cash, and accounts receivable. Intellectual property such as copyrights, trademarks, and patents are also assets. Liabilities include debts like loans, taxes owed, or accounts payable.
In this model, a business is valued as the sum of its parts. For example, if it owned $10M in assets and owed $5M in debts, the book value would be $5M.
2. Liquidation Valuation
The liquidation value is similar to the book value. It calculates what the owner would be left with if they closed the business, sold the assets, and paid all the debts. The key difference is that liquidation value is based on the market value (not the book value) of assets, reflecting what someone would actually pay for the asset. The book value is the purchase price minus depreciation, so it’s more of a theoretical number.
3. Earnings-Based Valuation
Many businesses are valued by examining how much money they make for their owners. The business value is often set as a multiple of annual earnings:
Value = Earnings x Multiplier
The multiplier is a significant variable in this equation, ranging from two to double digits. A business that earns $350,000 per year with a multiplier of two would be valued at $700,000, but if the multiplier is five, it would be valued at $1.75M.
Bigger multipliers are typically assigned to businesses with loyal, long-term customers, exclusivity in their local market, intellectual property, or unique business models. The earnings number could be net profit or EBITDA, with EBITDA often being larger as it includes earnings before taxes, interest on loans, and asset depreciation.
4. Times-Revenue Valuation
The times-revenue valuation is similar to the earnings-based valuation but uses revenue (or sales) instead of profit as the starting figure:
Value = Revenue x Multiplier
5. Discounted Cash Flow Valuation
This method uses free cash flow instead of multiplying profit or revenue:
Value = Free Cash Flow x Multiplier
Free cash flow is the annual profit left after paying for any maintenance or upgrades the business requires. Since calculating free cash flow is complex, this method is less common for small businesses. However, a trained business valuer can determine which of methods 3, 4, or 5 would provide the most favorable number for negotiations.
6. Entry-Cost Valuation
An entry-cost valuation estimates what it would cost to start a business similar to the one being valued. For example, if it would take $50,000 to build an equivalent business, the existing business is probably worth $50,000 too. However, adjustments must be made for the hassle of starting from scratch, the time involved in getting the business up to speed, and the investment needed to build goodwill with customers.
This method may be used to sense-check another valuation method. For example, if a times-revenue method results in a value of $300,000, but the entry-cost valuation gives just $100,000, further analysis is needed to find the true value of the business.
Valuing a Business Is Not an Exact Science
There are several ways to value a business:
- Sum of Its Parts (Book Value and Liquidation Methods)
- Earning Potential (Earnings-Based, Times-Revenue, Discounted Cash Flow Methods)
- Cost of Building an Equivalent Business (Entry-Cost Method)
The book value (or net worth) of a business is identified on your balance sheet, prepared by your accountant or bookkeeper at least annually. If you use software like Xero, you can create a balance sheet whenever needed.
However, when selling, the business might be worth more (or less) than the valuation suggests in the eyes of a buyer. Nonetheless, these analyses can help set expectations and guide negotiations, whether with a buyer, investor, or lender looking for security.
For more tips on preparing your business for the future, explore our guide to succession planning.
Ready to find out the value of your business? Contact BOA Financial today for professional business valuation services. Our experts can help you understand your business’s worth and guide you through the process. Get in touch for a consultation! Call us at 1300 952 286, 📧 email info@boanco.com.au, or visit www.boanco.com.au for a consultation.