When starting a business, you should always aim to calculate its valuation. What is valuation, and why is it essential for every business? Business valuation means the value of your company in the free market. Several methods determine it, but in the end, the value determines at what price a buyer may purchase or set a price for your business.
As an entrepreneur, you must understand what is valuation and how it measures business success. Later on, if you plan on connecting with investors to get funds for your business, they will also focus on business valuation and, based on that, provide the requisite funds to invest in your industry.
So, it’s clear that business valuation is a constant calculation that a business owner or an investor needs to do for their company to understand its growth trajectory and changing value in the market.
Why is business valuation important for business owners?
For entrepreneurs, there are several reasons why valuing your business correctly is important. While growth is an important metric we gain from it, business valuation has a lot to do with how others perceive your business's market value and whether they are willing to cooperate or invest in it.
Some of the reasons why business valuation is important are:
- Getting loans - Businesses expand by making use of the capital they get. Often, as entrepreneurs, you may require loans from financial institutions. When looking at your loan application, financial institutions will consider the business valuation. If your business has a strong value, your loan application can get approved per your stated terms.
- Investor funding - Investors look at your business valuation and potential ROI before injecting any funds. These metrics make investors more confident about the business. Also, many investors look for exit strategies - that is, if the company is sold, what the ROI would be? In such cases, a strong business valuation can help them determine or plan out an exit strategy with a good return on their investments.
- Taxation purposes - Calculating your business's value helps you calculate your taxes as well. For example, if your business is sold, the capital gain tax on the sale will be determined by your business valuation.
- Decision making - Finally, for an entrepreneur, knowing your business's valuation helps make strategic decisions. Business valuation helps create proper financial reports and, eventually, decisions on the growth and expansion of business.
Methods of calculating business valuation
There are several methods of how you can value your business. To calculate correctly, you should follow a proper business valuation guide to ensure you know what your chosen method represents. Each valuation method shows a different value. In this business valuation guide, we will talk about the method and its drawbacks.
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Market Capitalisation
This is one of the most popular methods of determining what is the valuation of your public business. In this method, the company's share price is multiplied by the outstanding shares. One of the drawbacks of this method is that it does not consider the debt owed by a company.
As a result, during a sale, the acquiring company needs to clear off this debt. This valuation is also readily available since it can only be done for public-traded companies.
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Asset Valuation
This is a simple method by which the company is valued per its net tangible assets. So, the difference between the total assets and the total liabilities is the valuation using such a method. There are two drawbacks to this method. It assumes that the business is still a going concern operating at its total capacity, which may need to be revised. Also, when sold, assets may fetch their partial estimated value so that it can be an imprecise method.
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Past Return on Investment (ROI) Performance
In this method, the value of a business is determined by its past performance. Whatever returns the company fetched in the past are calculated and extrapolated in future ROI predictions. This method is mostly used to understand the potential and efficiency of the company. However, one of the main concerns with this method is that a past metric cannot always stand true for future performance, mainly since it depends on market conditions, competition and other factors.
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Cash Flow Capitalisation
Cash flow capitalisation assumes a steady growth rate for the company and estimates the future cash flow values based on that growth rate. You determine what is the valuation of the company by adding these future cash flow values. Using the right financial modelling tools is an excellent way to create a predictable cash flow pattern in this method. However, it assumes that the company is growing steadily, which may need to be revised.
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Discounted Cash Flow
This is a more realistic method and a comprehensive way to determine the business value. Like cash flow capitalisation, in this method, the future cash flow estimates are considered as the value of the company. However, these cash flow estimates are discounted to their present value and thereby, they align with the time concept of money. As a result, any money earned today would be worth more than the same money earned in the future.
For this method, it is important to conduct proper financial modelling and forecasting to come to an accurate value. People who have done financial modelling certification courses for esteemed institutions are equipped to work on these models and determine the correct value of your company.
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Market Valuation
In this method, your business is pitted against similar businesses or competition in the same industry. By competitive analysis, a market value is reached on which the business is valued. One of the drawbacks is that this valuation depends on a lot of competition analysis which may not be precise. Also, in the case of any sale, there is a lot of negotiation and businesses are rarely sold at market value.
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Earning Potential
The earning potential method uses the earnings of the company as a metric to determine the future profitability of the company. By dividing the earning expectation of the company by the capitalisation rate, the present value of the company is determined. It is a good way to identify future earning potential, though it is heavily reliant on good financial forecasting and financial modelling.
What is the right method for you?
Now, you may be wondering, which business method would be the right one for me. It can be confusing at first, and honestly, there are no clear answers. However, there are a few standardised checklists that you can follow to choose the right business valuation method for you.
- For public companies - For public companies, the best method to find out what is the valuation is the market capitalisation method. It will bring public confidence in your company and give you a clear picture of your business. Private companies can opt for discounted cash flow or asset valuation.
- Growth stage - While you are determining the value of your company, you should also identify the growth stage that your company is in. If you have a good growth projection and have been in the business for some time, it would be a good option to go with an accurate method like discounted cash flow. However, if you are in the early stages, it would be very difficult to get accurate earnings potential and hence, it may not be the right method for your business.
- Purpose - Finally, what is the purpose for determining the value of your company? Whether you are looking for investor funding or you want to secure a loan, you need to choose the method that favourably reflects your business goals and value.
Conclusion
As discussed, business valuation is an important tool for entrepreneurs to understand the potential of their business. It showcases whether a business is healthy, and has a future and if the business keeps growing, what is the probable exit or buy-out rate. Hence, every entrepreneur needs to get their business evaluated and valued by a professional.
If you are looking to learn about financial modelling to help you value your business or another company, then you can enrol in the Postgraduate Financial Analysis Program by Imarticus. After learning from experts and going through a comprehensive syllabus, you will be equipped with the knowledge to create financial models and help entrepreneurs find out what is the valuation of their business.
Frequently Asked Questions
What is the most accurate valuation method?
The most accurate valuation method is the discounted cash flow method. In this method, since you determine the value based on future cash flows discounted at the present rate, you are considering the time value of money. This method also requires a comprehensive financial model to find out the value.
Do professionals help with business valuation?
It is advisable that you take the help of professionals with a proper financial modelling certification from esteemed institutions to find out the value of your business. Since your business valuation is important for securing loans, getting funds and also making business decisions, a professional can help you get the most accurate value using the right method for your business scale.
Are there any limitations to calculating business valuation?
While there can be different methods to get the value of a business, there is no way to accurately measure a business value. Each method has its own level of subjectivity and the investor or bank will perceive it based on the method used. However, if a professional makes a report they will clarify the methods used for valuing a business.
Is valuation just a number?
No, business valuation is an important metric that can be used to identify the strength of a business, make decisions on its growth trajectory and invite additional capital to grow or sustain the business.
