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Business valuation is a general process of determining the current economic value of a company or an asset. It is used to determine the fair value of a business for many reasons which include sale value, taxation, establishing partner ownership and even divorce proceedings. There are a number of techniques for performing business valuation and owners will often engage professional business evaluators for an objective estimate value of the business.
Business valuation is usually conducted when a company is looking to sell a part or all of its operations or looking to merge with or acquire another company. There are many factors to take into account when it comes to business valuation – company management, capital structure, potential future earnings or the market value of its assets.
The tools for evaluation can vary among evaluators, businesses and industries. Business valuation is also important for tax reporting. Some tax-related events such as sale, purchase or gifting company shares will be taxed depending on business valuation.
There are many ways how a company can be valued and these are 6 of the best practices:
1. Market Capitalization
This is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of outstanding shares. Eg. As of February 2021, Company Z traded $70.55. With a total number of 5 billion outstanding shares, the company could be valued at $70.55 x 5 billion = $352.75 billion.
2. Earnings Multiplier
The earnings multiplier method may be used to get a more accurate picture of the real value of a company since a company’s profits are a better and more reliable indicator of its financial success than sales revenue is. It is also called the price-to-earnings ratio (P/E), comparing a company’s current share price to its pre-share earnings.
Future profits are adjusted against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current P/E ratio to account for current interest rates.
3. Times Revenue
This method defines a stream of revenues generated over a certain period of time and applied to a multiplier which is dependent on the industry and its economic environment. Eg. A tech company may be valued at 5x revenue while a service firm may be valued at 1x revenue.
Times Revenue method is especially popular with individuals who own small businesses. They use it when they want to determine the approximate value of their companies so they can ensure proper financial planning and preparation before selling the business.
4. Discounted Cash Flow
Similar to the earnings multiplier method, this method is based on future projections of cash flows which are adjusted to get the current market value of the company. The main difference between these two methods is that it takes inflation into account to calculate and derive the present value.
5. Book Value
This refers to a company’s equity value as reported in its financial statements. The book value is typically viewed in relation to the company’s stock value; it is determined by taking the total value of a company’s assets and subtracting any of its liabilities the company is still owing.
Book value also takes depreciation into account in the book value of assets. It attempts to match the book value with the actual value of the company. It is typically grown per share, determined by dividing all shareholder equity by the number of outstanding common stock shares.
6. Liquidation Value
This is defined as the estimated amount of money that could be received quickly through the sale of an asset or company. In short, the liquidation value refers to the worth of physical assets of a company as it steps out of business.
It only takes in the value of the tangible assets unlike selling off a business that also takes into account the intangible assets. It is commonly referred to the cash value of a single asset.
In summary, the list of business valuation methods is not exhaustive and it forms the central basis of informed decision making for companies, both in the present and in the future. The future is unpredictable and companies need to prepare for uncertainty at all times in the event of unforeseen circumstances.