Business Valuation | Understanding the Most Common Approaches

Do you understand all the business valuation approaches possible when trying to sell your business? Which one is the best one? Find the answers inside.

Business Valuation | Understanding the Most Common Approaches

We talk to a lot of business owners who have spent decades building an impactful company that is important to the community.

However, the value will increase or decrease over time depending on how the business performs. Knowing the value of your company at any given time can be very helpful, especially when looking to appeal to investors or plan for retirement.

If you’re looking to get a business valuation, there are different approaches you can use to value your company.

Read on to learn the most common business valuation approaches and what they entail.

Why Is Business Valuation Important?

Business valuation is essential for understanding your company's health at any given time. And it's also important when you want to sell your business as it helps guide your pricing. Moreover, business valuation is essential when:

  • Securing funding from investors
  • Planning for retirement
  • Making strategic decisions
  • Increasing the value
  • Creating employee stock ownership plans (ESOPs)
  • Determining the estate tax value of a family-owned business

Related: Insightful Questions to Ask a Business Broker Before Selling Your Business

What Are the Most Common Business Valuation Methods?

Now that you know the purpose of business valuation, it's time to look into the various methods of valuation you can use.

The good thing about these strategies is that you don't have to be a financial expert to find the true value of your business. At Baton, we’ll determine which method is right for you and can get you a proper valuation in minutes.

1. Discounted Cash Flow (DCF)

Discounted cash flow (DCF) analysis is a popular method used by investors to estimate the value of a business.

The idea behind DCF analysis is that the value of a company is equal to the present value of its future cash flows. So, you discount the business's projected future cash flows by using a risk-adjusted discount rate. This gives you the business's net present value (NPV).

The downside of using this method is that it relies on several subjective assumptions. These include estimating future cash flows, choosing the right discount rate, and estimating the company's terminal value.

Some of the pros of using DCF analysis include:

  • It's useful for businesses with long-term contracts or high-growth potential
  • It takes a comprehensive view of the business by considering all cash flows

The cons of DCF analysis include:

  • It's difficult to estimate future cash flows accurately
  • It relies on too many subjective assumptions

You should use the DCF method when:

  • You're a long-term investor
  • The business has a high growth potential
  • You want to value the entire cash flow stream of the business

The DCF method is an income-based approach that looks at a company's future cash flows to determine its value. Therefore, it differs from other valuation methods, which may use earnings or book value measures.

DCF analysis considers the time value of money, meaning that a dollar today is worth more than a dollar tomorrow. One of the reasons for this is that you can invest a dollar today and earn interest on it, while a dollar tomorrow wouldn’t have had that opportunity.

This is why the discount rate used in DCF analysis is so important. It's the rate used to convert future cash flows into their present value. The higher the discount rate, the less valuable future cash flows become.

It's also important to note that DCF analysis doesn't just look at the business's future cash flows. It also considers the cash flows of its competitors.

This is known as the "component method." By doing this, DCF analysis can give you a more accurate picture of a business's worth.

Capitalization of Earnings Valuation Method

The capitalization of earnings valuation method is another income-based approach.

With this method, you determine a company's value by looking at its past earnings and estimating its future earnings potential. You then divide the company's current earnings by an appropriate rate to get its value.

This rate is known as the "capitalization rate." It's similar to the discount rate used in DCF analysis, but it's not as complex.

The capitalization of earnings valuation method is a simple way to value a company. However, it has its drawbacks. One is that it only looks at historical earnings. So, it doesn't take into account a company's future potential.

Another drawback is that it relies on the "earnings power value" (EPV) method. Therefore, it only looks at a company's earnings before interest, taxes, depreciation, and amortization (EBITDA). Such an approach can be misleading, as it doesn't consider a company's cash flow.

The main advantage of the capitalization of earnings valuation method is that it's easy to use. You can quickly estimate a company's value by looking at its past earnings.

You should use the capitalization of earnings valuation method when:

  • You want a quick estimate of a company's value
  • The company has a long history of stable earnings
  • You're comfortable using the EPV method

2. Multiples Valuation Method

The multiples valuation method is a comparative approach. It values a company by looking at similar companies.

With this method, you take a company's financials and compare them to the financials of similar companies. You then use these ratios to determine the value of the company you're trying to value.

This method is sometimes referred to as the "comparable companies analysis" or the "trading comps method."

The advantage of the multiples valuation method is that it's easy to use. You can quickly estimate a company's value by looking at similar companies.

The disadvantage of this method is that it's based on comparisons. This means it can be challenging to find comparable companies. It can also be difficult to find accurate financial information for these companies.

You should use the multiples valuation method when:

  • You want a quick estimate of a company's value
  • You're comfortable using comparisons
  • You can easily find comparable companies
  • Baton has a database of over 4 million companies with valuations, exits, and more to guide you through the valuation process.

3. Asset-based valuation

The asset-based valuation method is a balance sheet approach. This means it values a company by looking at its assets and liabilities.

This method calculates a company's value by subtracting its liabilities from its assets. This gives you the company's net worth or "book value."

The advantage of the asset-based valuation method is that it's easy to use. You can quickly estimate a company's value by looking at its balance sheet.

The disadvantage of this method is that it doesn't consider a company's earnings potential. This means it could undervalue a company with a lot of growth potential.

You should use the asset-based valuation method when:

  • Valuing companies in specific sectors like used car dealerships
  • Liquidating

4. Future Maintainable Earnings Valuation Method

The future maintainable earnings valuation method is a top-down approach. This means it values a company by looking at its future earnings potential.

In essence, FME is a simplified version of the Discounted Cash flow method. It's an ideal option when you expect profits to remain steady for the foreseeable future. Moreover, small businesses generally do not have sufficient information necessary for DCF models.

With this method, you look at the company's industry and market. You then use this information to estimate the company's future earnings.

The advantage of the future maintainable earnings valuation method is that it accounts for a company's future potential. This means it could be more accurate than the other methods.

The disadvantage of this method is that it's more challenging to use. First, you need to understand the company's industry and market well. You also need to make estimates about the company's future earnings.

You should use the future maintainable earnings valuation method when:

  • You want a more accurate estimate of a company's value
  • You have a good understanding of the company's industry and market
  • You're comfortable making estimates about the company's future earnings

Which Is the Most Used Approach in Business Valuation?

SDE multiples for SMBs are the most widely used approach for business valuations. This is a quick and easy way to value a company by looking at similar companies. It's also based on the EPV method, which is widely used in business valuation.

The main advantage of using SDE multiples is that it's easy to find comparable companies. It's also quick to estimate a company's value using this method.

The disadvantage of using SDE multiples is that it doesn't consider a company's future potential. This means it could undervalue a company that has high growth potential.

What Are the Limitations of Business Valuation Methods?

The main limitation of business valuation methods is that they're based on estimates. This means there's always a margin of error when valuing a company.

Another limitation is that valuation methods only give you an estimate of a company's value. They can't tell you what the company is actually worth.

The best way to overcome these limitations is to use multiple valuation methods. This will give you a range of values for the company. You can then use this information to make an informed decision about its value.

What Is the Best Method for Valuing a Company?

The best method for valuing a company depends on different things. These include the goals of the valuation and the type of company being valued.

Here are some of the valuation methods you may consider for different scenarios:

When you want to liquidate your company:

Asset-based valuation method is a good option when you want to liquidate your company. You can quickly estimate a company's value by looking at its balance sheet.

If you're valuing a company with a lot of growth potential:

The DCF method is a good option. This method takes into account a company's future potential and can give you a more accurate estimate of its value.

To get a highly accurate valuation:

A discounted cash flow analysis is the best option. This method accounts for a company's future earnings and cash flows to get an accurate estimate of its value.

A quick estimate of a company's value:

The multiples valuation method is a good option. You can quickly get an estimate of a company's value by looking at similar companies.

As you can see, different valuation methods are best suited for varying situations. As such, the best method for valuing a company depends on the specific goals of the valuation and the type of company being valued.

Why You Need a Business Valuation

Business valuation approaches are a helpful tool for determining the value of a company. However, they should not be used as the only source of information when making a final decision about a company's value.

Instead, it is essential to use multiple valuation methods to get a more accurate estimate of a company's worth. By doing so, you can make an informed decision about whether or not to invest in the business.

Are you looking to sell or purchase a business? If so, you need an accurate business valuation to help you get maximum value on your investment. This is where Baton can help. We offer business valuation solutions to both buyers and sellers. Visit our website today to access tons of content and tips and get started on your business valuation.