Three business valuation methods every entrepreneur should know
Houston accountants MGA explain the three methods used to determine the realistic and fair price for a business.
What is your business worth? There is no simple answer to this question, and yet, argue Houston accountants MGA, there are many important reasons to have a proper business valuation carried out for your company. For example, you may need to sell it, require debt or equity financing for expansion, or you may be adding shareholders. Potential investors will want to have a clear picture of your business’s intrinsic worth.
Whatever the reason for evaluating your company, how much it is worth depends on many factors. To ensure that its assets are adequately assessed and that you get the best price if selling, you really should get a business evaluation done by a professional. As we tell our clients in this situation, owners should never do their own business valuation.
The three business valuation methods explained
Any professional who evaluates your business, such as a professional accountant, will use several valuation methods to determine the realistic and fair price for your business. Read more below about the three basic valuation methods which are typically used:
1. Asset-based method
The asset-based approach of business valuation totals up a company’s investments. This option is best for owners who treat their business as an investment rather than as a significant source of income. It's a very straightforward approach and follows a simple rule: a company is worth the sum of its parts.
Asset-based business valuations can be done in two ways, as a going concern or on a liquidation basis.
- A going concern approach subtracts the value of a business’s liabilities from its net balance sheet value
- A liquidation approach determines the net cash that may be received after selling all assets and paying all liabilities.
2. Earning Value Method
The earning value method is based on the idea that a business's real value lies exclusively in its ability to create wealth in the future. The most-used earning value method for evaluating businesses is Capitalizing Past Earning.
With this method, the validator determines an expected level of future cash flow for the business using the company's record of past earnings, then normalizes them for out-of-the-ordinary expenses or unusual revenue and multiplies the expected cash flow by a capitalization factor.
Discounted Future Earnings is another variation of the earning value approach to business valuation. Instead of an average of past earnings, the validator uses an average value of the trend of predicted future earnings and divides it by the capitalization factor.
3. Market Value Method
The market value method establishes the value of a company by comparing it to other similar companies from the same industry that have sold recently. This method is not used unless there are a sufficient number of similar businesses for comparison.
The market value method is particularly difficult for sole proprietorships which are individually owned. Trying to find public information on prior sales of related businesses is far from an easy task.
A combination of methods can be the best way to go
The most popular business valuation method for most businesses is the earning value method. However, MGA believe that a combination of business valuation methods is the fairest way to determine a company’s value.
Time for a valuation?
Far too often, entrepreneurs, business owners, and CEOs do not think about having their company valued until it’s time to sell, expand or add investors. Then it’s a scramble to determine the company’s worth. To avoid similar problems, MGA provide a wide variety of advisory and consulting services designed to take the complexity out of business valuation and give you peace of mind. Contact MGA in Houston for assistance.