Knowing your company’s worth provides critical insight for making strategic decisions and charting the optimal path forward. However, accurately valuing a business requires in-depth financial analysis using proven approaches.
While quick online calculators can generate ballpark figures, serious leaders turn to the main valuation methodologies accepted by the finance community. Mastering these techniques helps set realistic value expectations when seeking funding, pursuing mergers and acquisitions, succession planning, and resolving shareholder disputes.
The Market Approach
The market approach derives value from the sales prices of comparable companies. It analyzes what similar businesses in your industry recently sold for based on financial metrics.
To start, identify at least five direct competitors or companies with very comparable offerings and markets. These firms should have been acquired or undergone an IPO in the last two to three years.
Next, research the valuations and key financial ratios of the comparables when transacted.
Common metrics analyzed include:
- Price/Earnings (P/E) ratio
- Enterprise Value/Revenue (EV/Revenue)
- Enterprise Value/EBITDA (EV/EBITDA)
Take the average of each multiple across the peer group. Finally, apply those averages to the corresponding financial performance numbers for your company.
This market-based technique provides a quick snapshot of potential value. However, it depends heavily on the availability of transaction data for suitable comparables. The approach also fails to account for differences in growth outlook between your company and the peer group.
The Income Approach
Income approaches calculate value based on projected profits and cash flows rather than on past earnings or assets. Forecasting future performance requires financial modeling and assumptions but gives a forward-looking perspective.
The two main methods here are the Discounted Cash Flow (DCF) model and the Capitalized Cash Flow (CCF) technique.
Discounted Cash Flow (DCF) Model
The DCF model projects your company’s free cash flows over the next five to ten years. These projections account for estimated revenue growth, operating costs, capital expenditures, taxes, working capital changes, and debt payments.
The annual cash flows are then discounted to today’s dollars using your weighted average cost of capital (WACC). This compensates for the time value of money and investment risk.
Adding the discounted cash flows provides the net present value – an estimate of current business value based on future earnings potential.
Creating accurate projections requires intimate knowledge of your operations, markets, and growth strategy. Small errors compound over the 10-year horizon, significantly impacting the valuation.
Capitalized Cash Flow (CCF)
The capitalized cash flow method is a simpler income approach. It divides maintainable pre-tax earnings by a capitalization rate or earnings multiple.
Maintainable earnings represent normalized future profitability, not necessarily last year’s net income. This forward-looking figure must deduct discretionary expenses like excess owner’s compensation.
The earnings multiple derives from your company’s growth prospects and industry averages. Multiples typically range from 3 to 10 times profit depending on the risk, capital intensity, and sustainability of returns.
Like DCF models, CCF valuation is highly sensitive to cash flow estimates. It also requires defending your normalization assumptions.
The Asset Approach
Asset-based valuation sums up all tangible assets and deducts liabilities to give a net asset value. This approach best applies to real estate, manufacturing, oil and gas, and other capital-intensive businesses.
To implement:
- Catalog all assets and their fair market value – equipment, real estate, inventory, vehicles, etc.
- Assess all liabilities like accounts payable, debt, and other financial obligations.
- Subtract total liabilities from total asset value.
A limitation is that this technique only considers historical asset costs. It fails to account for intangible assets like intellectual property, brand equity, talent, and processes.
Essentially, the method reveals liquidation value but falls short in assessing ongoing enterprise
value.
Blended Valuation Approaches
Flaws inherent in the individual methods lead some to blend two models into a hybrid valuation approach. Common combinations include:
- Market Comparables and Discounted Cash Flow (DCF): Averages the ratio multiples from recent transactions and merges them with an independent DCF analysis. This offsets the short-term market view with long-term cash flow forecasts.
- Weighted Average: Values a business by applying weights to different approaches based on their relevance to the company’s specific situation. This provides a balanced composite.
- Sanity Check: Cross-verifies whether independent market, income, and asset valuations reasonably agree or diverge significantly. Exploring outliers enhances objectivity.
Blending methods offset the weaknesses in standalone models to reach an informed, rounded estimate of business value.
Key Valuation Adjustments
After applying primary approaches, certain valuation adjustments better reflect a company’s actual worth:
- Control Premiums: Recognize the increased value of a controlling stake granting decision-making power versus a passive minority share.
- Marketability Discounts: Account for the decreased value of an illiquid ownership interest versus publicly traded securities.
- Industry Outlook: Incorporate growth trends, competitive forces, and macro conditions influencing future prospects.
- Company risk: Assess technology risk, supplier/customer risk, regulatory risk, financial risk, and funding needs.
- Key Person Discount: Consider the impact of losing an important founder, CEO, scientist, or other individual vital to success.
Avoid mispricing by carefully factoring in these influencers of value and saleability.
Formal Valuation Assessments
For major transactions like equity raises, M&A deals, litigation, estate planning, and marital disputes, do-it-yourself valuations carry too much risk.
Seeking a formal business appraisal from a certified professional ensures you meet due diligence requirements and global valuation standards. It also provides a defensible estimate that protects all parties’ interests in significant corporate actions.
Formal valuations require extensive information gathering, verification procedures, complex modeling, and careful analysis by specialized practitioners.
Common credentials held by business valuation professionals include:
- Certified Valuation Analyst (CVA)
- Accredited Senior Appraiser (ASA)
- Certified Business Appraiser (CBA)
- Accredited in Business Valuation(ABV)
Though expensive, formal valuations give peace of mind and legal confidence when the stakes run high.
Key Takeaways
Estimating your business value lets you make smart moves but demands rigor. Keep these guidelines in mind:
- Match the approach to your needs: Simple market or asset methods work for quick internal assessments, while blended income techniques support transactions or due diligence.
- Forecasts drive income models: Invest time in building reliable financial projections and normalization assumptions.
- Market data brings realism: Keep valuation grounded by factoring in multiples paid for by peers.
Weight strengths and weaknesses: Offset limitations by combining market, income, and asset-based approaches. - Adjust for value influencers: Incorporate control, liquidity, risk, and growth factors.
Turn to the professionals when required: Valuators certified in globally accepted standards add credibility to major events and disputes.
Business valuation is both an art and a science. With diligence and skill, you can value your company with reasonable accuracy. Just ensure the approach matches your goals and needs.
Unlock the True Value of Your Business with Cendrowski Corporate Advisors
At Cendrowski Corporate Advisors, our team of certified professionals specializes in business valuation so you can unlock the insights you need for informed decisions. Whether you’re looking for funding, exploring mergers and acquisitions, planning for succession, or resolving shareholder disputes, we are here to help.
Don’t rely on guesswork or quick online tools to determine the value of your company.
Contact us today for a formal valuation assessment that adheres to global standards!