How To Value a Business: 9 Key Methods

Whether you’re looking to sell your business in Kansas City or elsewhere, valuation is essential for strategic planning, investment analysis, and potential mergers or acquisitions. This article aims to equip business owners with a comprehensive overview of the key valuation methods, helping them to make informed decisions about the best approach for their unique business situation.

What is Business Valuation?

Business valuation is the process of estimating the price for which a buyer and seller would agree to in an arm’s length transaction. Business valuation can be used to determine the fair value of a business for various reasons. 

Calculating business valuation can help establish sale value, establishing partner ownership, taxation, and even divorce proceedings. Understanding what a buyer may pay for the business is crucial for making informed decisions during any transaction or financial assessment.

The Importance of Business Valuation

The importance of business valuation extends beyond just the selling price of a business. Valuations help owners avoid underselling their business or setting unrealistic price expectations that deter potential buyers. Moreover, it provides a benchmark against which the performance of the company can be measured.

A Couple of Considerations

Business valuations can be an important decision-making tool, and in some cases, are required for regulatory or legal purposes.

Most business valuation opinions will have the following paragraph:

For the purposes of business appraisal, fair market value is defined as the expected price at which the subject business would change hands between a willing buyer and a willing seller, neither being under the compulsion to conclude the transaction and both having knowledge of all relevant facts.

So, before you decide to spend $5,000, $10,000, or $40,000 on how to value your business — be very sure why you need it. There are some requirements to value your company for tax purposes. If you are in any kind of partnership or marriage dispute, you probably need a certified valuation.

Different Valuation Methods and What They Say About a Business

If you want to use the information you receive from a valuation to manage your company more strategically, you probably can do so with a standard estimate of value.  Banks use a form of this for just about every acquisition loan. For instance, if the valuation uses three methods, the following situations may apply:

- You might see a significant difference between your valuation as a multiple of sales versus a multiple of profit. That could mean that your profit margins are lower than industry expectations, so you need to explore some industry key performance indicators.

- If your asset-based valuation (definition  below) is much higher than your Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Multiplier (definition  below), then you may be underutilizing your assets.

- If your Discounted Cash Flow Valuation (definition  below) is much higher than your EBITDA Multiplier, you should develop a very strong, actionable growth plan with capital and staffing requirements carefully delineated.

If you have made the decision to sell your business in Dallas or just need a general idea of what you might get, a Rule of Thumb valuation (definition  below) might meet your needs. Some mergers and acquisitions (M&A) firms charge for this (usually less than $1,000), and some will provide it as part of their sales process.

After all, if a valuation gives an estimate of the price a buyer and seller would agree to, why not just go to market and find out the facts rather than rely on an estimate?

9 Key Methods for Valuing a Business

Business valuation methods vary depending on the industry, financial health, and other factors. Below are nine key methods used to determine a company's worth.

1. Market Capitalization

Market capitalization is the simplest valuation method, applicable only to publicly traded companies. It is calculated by multiplying the company's stock price by its total number of outstanding shares. This method reflects the market’s view of a company’s stock value. Since stock prices fluctuate due to external factors such as economic trends and investor sentiment, market capitalization can be volatile.

Think about market cap as the daily result of an irrational marketplace bidding prices on a number of factors. If you have ever followed the price of a stock just before a merger, you may have noticed that the price jumps all over the place. That is because rational buyers are stepping in to take control of the company. They are buying for underlying value, not for a 10% return on a commodity.

For example, if a company has 10 million outstanding shares priced at $50 each, its market capitalization is $500 million. This method provides a real-time estimate of how to value a business by a company’s worth; it does not consider factors such as debt, future growth, or market conditions affecting private companies.

2. Asset-Based Valuation

The asset-based valuation method calculates a business's total net asset value by subtracting its total liabilities from its total assets. There are two approaches:

• Going Concern Asset-Based Approach: Assumes the business will continue operating, valuing assets based on the future profits generated by the assets. Financial statements prepared according to Generally Accepted Accounting Principles (GAAP) attempt to reflect this value. However, GAAP does not consider key market factors such as inflation of availability
• Liquidation Asset-Based Approach: Estimates the cash the company would receive if all assets were sold and liabilities paid off.

This method of how to value a business is often used for asset-heavy businesses like equipment rental and real estate. However, it does not account for intangible assets like brand reputation or goodwill.

3. Earnings Multiplier

Rather than valuing a company based on book value or tangible assets, the earnings multiplier method applies a multiple to the company’s earnings. The multiple is based on industry trends, economic conditions, and the company's financial health.

For example, if a business generates $1 million in profit annually and the industry’s average earnings multiple is 5, the business would be valued at $5 million. This approach is commonly used for businesses with stable revenue streams.

4. EBITDA Valuation Method

The EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) valuation method determines how to value a business based on its earnings before accounting for financial obligations and depreciation.

EBITDA valuation attempts to value the core cash flow of the business. The depreciation and amortization are non-cash expenses that attempt to reflect the annual cost of long-term assets over their useful lives. Interest and taxes can be greatly impacted by tax planning and capital strategies that change with new ownership.

Multiples for EBITDA vary by industry. For instance, service-based businesses might have lower multiples (3-5x), while high-growth tech companies might have higher multiples (7-10x). 

Why is that? A tech company can leverage its assets into a broader geographic market, which usually has a lower penetration rate and a higher gross margin level. This method is useful for investors looking to compare profitability across businesses without financial distortions.

5. Discounted Cash Flow (DCF) Analysis

DCF is one of the most detailed methods on how to value a business. It projects future cash flows and discounts them back to the present value, factoring in the time value of money.

Steps in DCF analysis:

1. Forecast future cash flows over a set period.
2. Determine the discount rate (starting with the weighted average cost of capital and building for a number of risk factors relevant to the company being valued).
3. Discount projected cash flows to present value.

A business with significant growth opportunities, above and beyond its industry segment, must use this method to reflect the core value of its business. However, this method requires accurate forecasting and can be complex. This method requires a sophisticated buyer to assess the forecasts and discount factors, as well as execute the growth plan.

6. Comparable Company Analysis (CCA)

The CCA method is only valid for publicly traded companies compares a business to similar publicly traded companies, using financial metrics like revenue, EBITDA, or profit margins to determine value.

For example, if similar companies in the industry trade at 4x revenue, and a business generates $10 million in revenue, the estimated valuation is $40 million. This method works best for industries with readily available market data.  

7. Precedent Transaction Analysis

This method is the most popular method for valuing private companies. Similar to CCA, this method examines past transactions involving similar businesses within the same industry and market conditions.

By analyzing acquisition prices, revenue multiples, or EBITDA multiples from previous deals, business owners can better gauge how to value their business. This method is particularly useful in M&A transactions.

8. Rule of Thumb Methods

The rule of thumb valuation methods rely on industry-specific formulas and historical pricing trends. Many industries have established multipliers based on revenue, profit, or customer base.

For example:

- Restaurants may be valued at 3x annual revenue.

- Law firms might be valued at 1.5x annual revenue.

Depending on your need for valuation information, simple, rule-of-thumb methods should not be the sole valuation tool, as they often fail to account for unique business circumstances.

9. Intangible Asset Valuation

For businesses with significant intangible assets such as patents, trademarks, brand reputation, and customer relationships, intangible asset valuation is critical.

Several methods exist for valuing intangible assets:

- Relief-from-Royalty Method: Estimates the hypothetical cost of licensing the asset if the company did not own it.

- Excess Earnings Method: Determines the earnings generated specifically from intangible assets.

For example, a technology company with a strong patent portfolio might command a higher valuation than a similar-sized business without proprietary technology. 

These can be extremely complex, but are just another form of the Discounted Cash Flow method.

What Are The Tax Implications of Selling My Business? 

Before you sell, it’s important to understand the potential tax implications of the sale. Research capital gains tax, as well as alternative tax strategies to help you actively reduce tax burden (such as seller financing or installment sales). Speaking with a tax professional can give you a full understanding of how much you’ll owe, along with ways you can mitigate excessive tax fees. 

How to Choose the Right Valuation Method

Selecting the right method  on how to value your business depends on various factors:

• Industry Type: Asset-heavy businesses benefit from asset-based valuation, while SaaS companies might rely on DCF or EBITDA multiples.
• Growth Stage: Startups may rely on DCF, while established companies might use CCA or precedent transaction analysis.
• Market Conditions: Businesses in fluctuating markets may need a blended approach to account for volatility.

Often, business owners use multiple valuation methods to get a well-rounded estimate of their company’s worth.

Common Pitfalls to Avoid in Business Valuation

1. Using Only One Valuation Method

Over-reliance on a single method can result in an inaccurate valuation. A blended approach often provides a more precise estimate. When using multiple methods, business owners need to understand the different results generated by the methodologies.

For instance, many private company valuations analysts use a weighted average of three methods: Asset, EBITDA and DCF. We have seen valuation drafts where the Asset method generated a $4.5M valuation, the EBITDA a $6M valuation, and the DCF resulted in a $14M valuation. It would not be appropriate to average these until management can understand the variations.

2. Ignoring Market Conditions

Economic trends, industry downturns, and competitor valuations impact business worth. Owners must consider these factors when valuing their business.

3. Underestimating Intangible Assets

Many business owners focus on tangible assets while ignoring the value of brand reputation, intellectual property, and customer loyalty.

4. Failing to Adjust for Risk

Businesses with inconsistent cash flows or high market risks may require valuation adjustments to reflect potential financial instability.

How a Business Broker Can Help Value a Business

Business brokers provide expertise in selecting the best methods on how to value a business, ensuring accuracy in pricing a business for sale. Their market knowledge allows them to benchmark valuations against similar transactions, improving a company’s marketability.

The bottom line is that business brokers work with buyers and banks every day. No matter what methods are used for valuation, brokers understand how those with the money (buyers and banks) assess companies in different industries.

Take the Guesswork Out of Your Business Valuation

IBEX Middle Market Business Brokers understand business valuations and help owners understand their company’s value. With expert guidance, business owners can navigate the complex process of valuation and maximize their sale price.

Understanding your business’s value is an important step to a successful sale. By using the right valuation methods and consulting experienced professionals, you can ensure that your business is positioned for the best possible outcome.

For more information and to get started today, please connect with us online or via (512) 310-2966. It’s our pleasure to serve you.