What Is A Business Valuation? (With Definition And Types)
By Indeed Editorial Team
Published 16 October 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Businesses require knowing their market value to assess their current financial health and future exit strategies. Business valuation is the process of obtaining an approximate estimate of a company's value. If you work in finance, you can benefit from learning how companies determine their market value. In this article, we discuss what a business valuation is, learn why it is important, examine various methods available to value a business and review some tips to value a business effectively.
What Is A Business Valuation?
A business valuation is a process through which companies assess their present worth by translating their brand, products, services and market into capital. Business owners typically perform a valuation when expanding their business, merging with other companies, negotiating during an acquisition or selling parts or all of their business. A certified appraiser, a business advisor or an investment firm can value a business.
Why Is This Valuation Important?
Valuing a business is important for the following reasons:
Knowledge of company assets: Performing periodic valuations allows companies to estimate the value of their capital assets.
Mergers and acquisition: Large companies may want to acquire smaller businesses to expand their market share. When companies have an estimate of their value in the market, they can negotiate better during acquisitions.
Better investment opportunities: Companies may seek additional investment to expand their business operations and focus on research and development activities. Performing a valuation of their business allows companies to showcase their progress and provides revenue projections to attract potential investors.
Measurement of progress: When performed regularly, valuations are a good measure of a business's progress. It is important for a company to include valuation as part of its strategic business plan.
Sets a benchmark: Limited information is available on the sale prices of various businesses. Valuing a company provides a benchmark price, which is a good reference for buyers and sellers.
6 Methods To Value A Business
Here are six methods to value a business:
1. Market value
The market value method estimates the value of a business by comparing it to similar businesses that have sold in the past. This technique requires sufficient market data of other competitors in the same field. This method is subjective and may not accurately measure a business's worth. The finance team of a company can use this method to understand how much the company might be worth. After this, they can use other approaches to obtain a better estimate.
The asset-based method calculates a business's net value by aggregating all its assets and subtracting the liabilities. This is the value that a company would generate upon liquidation. The company requires paying its preferred and common shareholders upon liquidation. If a business operates as a going concern, it may do so given that it has enough resources to continue its operations. This is the non-liquid approach. An asset-based technique is an accurate measure of a company's value and is suitable for companies with low profits and valuable assets. Here is the formula:
Business value = total assets - total liabilities
Total assets = fixed assets + current assets
Total liabilities = fixed liabilities + current liabilities
The return-on-investment (ROI) method calculates the ROI that an investor may receive upon investing in a business. This technique is suitable for companies of different sizes. This approach is subjective due to market conditions and the company's performance over a period. Investors interested in investing in a company may focus on factors such as the returns they would get after a period, the duration after which they would get back their investment and the period after which they would make an actual profit. Find the formula below:
Business value = initial investment / percentage of equity allotted
ROI for an investor = (net income / cost of investment) x 100
4. Market capitalisation
The market capitalisation method calculates the value of a business by multiplying the current share price with the number of outstanding shares issued. Outstanding shares include all shares issued to shareholders and company executives. You can get this value by subtracting treasury shares from the total stocks issued to stockholders. Treasury shares, also known as reacquired stock, include all outstanding shares that the company bought. The current share price, also known as the market value, is the value at which it is trading in the market. Review the formula for market capitalisation:
Market capitalisation = current market price per share x number of outstanding shares
Outstanding Shares = total issued stock – treasury shares
5. Capitalisation of earnings
The capitalisation of earnings method values a business based on its expected future performance, determined by its cash flow, the annual rate of return and expected value. The expected value of a business forecasts the value of an investment over a period. Investors can use this technique to evaluate potential risks and the rate of return when investing in a company. The required rate of return or capitalisation rate depends on various factors, such as the type of industry, growth expectations, nature of business and market conditions. Here is the formula:
Business Value = annual future earnings / required rate of return
6. Multiples of earnings
The multiples of earnings method values a business by incorporating various financial metrics from companies with similar business structures and operations. This method applies a multiple to a company's earnings for its valuation. The multiplier may depend on factors such as the industry type, company age, revenue trend and debt. This technique is simple and allows investors to get an estimate of a company's worth.
This method does not account for a company's intrinsic value and growth. There may also be misinterpretations because similar companies have different accounting principles and policies. Below is the formula:
Business value = earnings of a business x multiplier
3 Examples Of Valuing A Business
Here are some examples to help you understand some techniques used to value businesses:
1. Market capitalisation
Below is an example of valuing a business using the market capitalisation method:
A company's share price is ₹350 in the stock market. It has issued a total of 10,000 shares. It has 2000 treasury shares. In the first step, calculate the outstanding shares by subtracting 2000 from 10000. Multiply this with the share price. The market capitalisation is 8000 multiplied by 350, which is ₹28lakh.
2. Asset-based valuation method
Here is an example of an asset-based valuation method which involves subtracting a company's total liabilities from its total assets:
A company has an inventory worth ₹14 lakhs, land and buildings worth ₹40 lakhs and cash and cash equivalents worth ₹10 lakhs. It has a long-term debt of ₹15 lakhs and accounts payable of ₹5 lakhs. The total assets equal the sum of both fixed and current assets, which is ₹64 lakhs. The total liabilities equal the sum of current and non-current liabilities, which is ₹20 lakhs. Subtracting total liabilities from total assets gives ₹44 lakhs. The market value of this company is ₹44 lakhs. This is the amount that the shareholders would receive during liquidation.
3. ROI-based valuation method
Here is an example of an ROI-based valuation method for a business:
An e-commerce company seeks funding of ₹50 lakhs from an investor by allowing 10% of its equity to the investor. The valuation of the business is ₹5 crores, obtained by dividing 50 by 10%. This implies that an investor owns 10% of the issued stocks, shareholder votes and dividends paid by the company every month or quarter.
Tips For Determining A Business's Value
Here are some tips that analysts and other financial professionals can follow when performing a valuation:
Decide a valuation method. Choosing a suitable valuation method depends on factors such as the nature of business, type of industry, size of a company and market conditions.
Estimate the growth rate. Growth rate refers to the change in a variable over a period. The variable considered can be gross profit, churn rate and new customers.
Analyse competitors. Companies can benefit from gathering data about other businesses in the same industry to understand their economic value in the market. The collected data can provide insight into new products, sales, marketing and pricing strategies.
Determine profitability. Businesses with higher net profit attract potential investors. It is important for companies to evaluate their profitability and improve it by studying their sales and revenue data.
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