What are Valuation Methods?
Valuation methods are the methods for calculating how much a company is worth now or how much it will be worth in the future.
Investors, lenders, buyers, and sellers frequently need to know the value of a business to make good financial decisions, and that’s when valuation methods come into play.
Valuations are common in the world of corporate finance for sales, acquisitions, or mergers. Although valuation methods are quantitative, it doesn’t mean they’re always cut-and-dry. Finance professionals frequently use multiple valuation methods to arrive at a fair valuation for a business.
Why do we need valuation methods?
When you do a valuation, you’re analyzing a business to see how much it’s worth. While valuation calculations are quantitative, they’re both an art and a science; in fact, different valuation methods can yield very different numbers.
You might need to do a valuation for:
- A divorce. Company ownership counts as an asset, so a court may need to know how much the business is worth.
- Taxes. The IRS will tax you on purchased or gifted shares, so the amount you pay in taxes is based on your valuation.
- Buying or selling a business. Buyers need to know how much a company is worth so they don’t over-pay. Sellers also need a fair valuation so they don’t sell the business for less than it’s worth.
- Financing. Both banks and investors want to know the value of a business so they can determine ROI.
Because every party has something to gain, it’s important to hire an impartial third party for a business valuation. This way, everyone is protected and the business is valued at the fairest price possible.
The 4 most common valuation methods
There’s no single “right” valuation method. However, finance professionals often use these 4 valuation methods to calculate the fair market value of a business.
The easiest valuation method subtracts a business’s liabilities from its assets. You can do this by looking over the balance sheet, listing all assets, and subtracting liabilities.
For example, if a company has $100,000 in assets and $10,000 in liabilities, the company value would be $90,000.
But this can be too simplistic for most transactions. Another way to do an asset-based valuation is the liquidation method. The liquidation valuation method calculates how much cash you would earn if you sold all of the assets and paid off your liabilities.
For example, if the business sells its assets but only makes $80,000 (instead of the $100,000), it would be worth $70,000 after paying off its liabilities. The liquidation method takes the realities of selling on a market into account, so this is usually a more accurate valuation.
2. Earning value
Earning value looks at how much wealth a business will create in the future. In other words, you’re looking at the potential of a business.
To do this, you’ll look at the company’s past earnings and divide them by a “cap rate” for that industry. For example, if the business earned $2M last year and the cap rate for the industry is 5%, the business is worth $40M.
3. Market value
The market valuation method compares a business to similar companies that sold recently. This is very similar to real estate “comps” you see when you’re shopping for a home.
Market value is useful because it accounts for the market as it is today. However, you need to have a good amount of similar companies to compare the business against. Otherwise, the data sample won’t be large enough for a fair estimate.
4. Discounted cash flow
Discounted cash flow (DCF) is a popular valuation method because it takes inflation into account.
The DCF valuation method forecasts a business’s cash flow in the future and then discounts it. So, instead of looking at past earnings, you’re predicting future performance and adjusting the current value of the company based on that performance.
Which method is best?
There are so many valuation methods to choose from. What’s best for your situation?
It depends. Earnings-based approaches are most popular, but the best way to come to a fair price is to use multiple valuation methods. Calculate 3 to 4 valuations and average them to arrive at a fair price. Be sure to show your math so you can justify the number to your buyer, seller, investor, or another third party.