Business valuation is a quantitative process of assessing a company’s economic value in the market based on its current assets and future earnings. Regular business valuations can help assess an organization’s performance. It also identifies innovative ways to increase the business’s overall value and gain more investors.
Moreover, companies also use valuation to plan exit strategy (selling the company) by obtaining the true market value. Therefore, it is important to conduct annual business valuations to see whether a business is growing according to the initial plan.
Unfortunately, a perfect way to determine business market value does not exist because value estimation is conducted on multiple financial levels. Since the valuation process, formulas, and strategies are different for calculating each company’s market value, most companies use business appraisal services to obtain accurate results.
Three Approaches for Determining Business Market Value
There are three approaches to determining a business’s market value. Companies can utilize one or more depending on the business model and objectives. For instance, businesses can use these strategies to extract information about a business’s potential to attract probable investors or buyers.
The asset approach focuses on the company’s net asset value to determine the equity value. In this method, the market value balance sheet is evaluated to identify the difference between assets and liabilities of the fair market. Companies can decide which assets and liabilities should be listed for the valuation and which formulas should be used to measure their worth.
In most valuations, companies adjust the assets’ estimated value to fair market value. This is because the reported value of assets (minus liabilities) differs on the balance sheet due to certain factors, such as the time gap between valuations.
After asset adjustment, the newly adjusted assets’ value is evaluated through recorded and unrecorded liabilities. Companies use this approach when planning a sale or liquidation.
The income approach, also known as income capitalization, is a business valuation method mainly used by real estate agencies. However, other business industries can also use it to learn their worth in the market.
Real estate companies apply the income approach to estimate a property’s value based on how much income it generates. For the calculation, the net operating income (NOI) of a property’s rent is divided by the capitalization rate.
Meanwhile, other industries can determine their market value by calculating the future worth of current assets. The estimated economic benefits or future cash flows are accumulated to show the company’s worth. In short, this method shows how much financial profits a company is expected to produce in upcoming years based on its existing assets.
The income approach further branches into two sections:
- Single Period Method: It calculates the base level of annual profits to predict a sustainable growth rate.
- Multi-Period/Discounted Cash Flow (DCF) Method: It calculates the value of an investment based on future cash flows during a discrete projection period. After the discrete projection period is over, the company is predicted to grow at a steady rate. If this occurs, the DCF method is converted into the single-period method.
The market approach determines the market value of an asset by evaluating the current sales price of comparable assets. As equivalent assets have identical characteristics and produce similar benefits, they are effective in appraising the worth of existing assets.
The company’s valuation surveys the rates of recently sold similar assets to appraise existing ones. However, if the assets are different, the valuator must make various adjustments to ensure business valuation produces correct results.
Organizations use business valuation to learn their current value in the market. It helps in understanding the company’s potential growth rate. As a result, new and informed financial goals and business strategies can be developed to improve the company’s market value.
Businesses can combine three valuation approaches or use them separately to meet their objectives. They can also acquire a business valuator to correctly calculate each asset’s final estimated worth.