Valuation Models for Business

When determining a fair value for a business, both the buyer and the seller should assess the company using one or preferably multiple valuation principles. The outcomes of these valuation methods depend on the values used and should be considered as guidelines. During negotiations, it is crucial to explain the assumptions that form the basis of your valuation.

• Liquidation Value
• Substance Value
• Cash Flow Valuation
• Multiple Valuation
• Relative Valuation
• Historical Earnings Capacity

Regardless of the valuation model used, always have access to figures such as semi-annual or quarterly financial statements.

Liquidation Value

Liquidation value, also known as scrap value, is the amount that can be obtained from selling the company’s assets if the business ceases operations and liabilities are paid off. This should be the minimum acceptable value in a transfer scenario, as the alternative is to liquidate the business.

Substance Value

The simplest way to value a business is through substance value, which involves calculating the value of assets minus liabilities. All assets and liabilities should be valued at the time of the business valuation to identify any under- or overvaluations in the balance sheet. Differences often arise in the recorded versus actual value of assets like real estate and intangible assets such as source code.

Cash Flow Valuation

Cash flow valuation is the most commonly used principle, involving the present value calculation of the company’s future operational cash flows. This method requires a detailed forecast of the income statement and balance sheet for the next 5 to 10 years, along with growth assumptions. Each year’s future operational cash flow is discounted to its present value, using a discount rate based on the average interest on interest-bearing debt and the required return for a new owner. This method focuses on future cash flow, which is of interest to the buyer, but it carries significant risks due to potential errors in assumptions.

Multiple Valuation

Multiple valuation involves multiplying earnings or revenue by a factor that varies by industry and whether it is based on earnings or revenue. Generally, larger, well-managed companies have higher multiples, while smaller, owner-led companies have lower multiples. This method can be applied to historical or forecasted figures, especially for companies expected to have similar future revenue and earnings.

Relative Valuation

Relative valuation uses current valuations of similar companies, such as recent acquisitions or publicly traded companies, to set a value for your business. If sufficient similar company valuations are available, the average and median of these multiples can be applied to your business to derive an implicit value. It’s essential to objectively assess what differentiates your company from these comparable ones and whether to apply a discount or premium in the valuation.

Historical Earnings Capacity

Another common approach is to consider the company’s historical earnings capacity over time. This complements other valuation principles by providing a basis rooted in actual performance. Historical data is used to forecast the company’s economic development over the next five years.

Definition of Company Value

Start by defining your company value. Two common definitions are Market Capitalization and Enterprise Value. Market Capitalization (market cap) is the market value of a company’s shares, calculated as the share price times the number of shares. Enterprise Value (EV) includes the total value of a company, combining equity and debt. EV = market cap + interest-bearing debt – cash. This adjustment is necessary because the owner is responsible for the company’s debts, which must be repaid eventually.

Factors Affecting Business Value

Several factors influence a business’s value, including:

• Growth
• Profitability
• Business plan (potential)
• Market size
• Market potential
• Scalability
• Business value
• Assets
• Risk

Assessing Business Risk

Future risk is one of the most critical factors affecting a company’s value. The higher the associated risk, the higher the return a buyer will demand, which typically lowers the business’s value. Sellers should thoroughly address and mitigate various risks to provide buyers with confidence.

Cost of Business Valuation

The cost of a business valuation varies depending on factors like company size, industry, complexity, and purpose. Generally, valuations can range from a few thousand to tens of thousands of dollars or more. A basic valuation for a smaller company by a qualified accountant or business broker typically costs between $1,000 and $5,000. More advanced valuations involving international aspects or intangible assets can be higher.