Three Methods of Calculating Business Valuations

Business valuation report

There are a lot of reasons one would use a company valuation tool:

  • Perhaps you’re trying to gather capital to start or expand your business; a company valuation tool would help you determine the value of your business and how much equity you will need to exchange for capital.
  • Perhaps you’re selling your business to someone else and need to show how much money the company can make to determine how much to sell it for; you guessed it, you’d use a company valuation tool to determine that.
  • Perhaps you’re liquidating your business and need to determine the value of your assets to pay off your creditors; you’d use a company valuation tool to do that.

However, each of these scenarios involve a different point-of-view of your business, and involve a very different business valuation analysis that results in a different overall valuation. It doesn’t make the differing valuations inaccurate, it’s just serves a different purpose. The three most common business valuation approaches are outlined below:

Three Methods of Calculating Business Valuations

  1. Valuation Market Approach

    Let’s say your business is fairly new to the market. You don’t have years of income statements to show how much money you can generate. You don’t have many assets, because you’re just getting started. You’re trying to collect investors or lenders who are willing to give you cash in exchange for equity in your business or your repayment with interest. You would probably use the market approach to determine the value of your business. The market approach looks at the value that other businesses that are similar to yours have sold for recently.

    This might go without saying, but this method of valuation only works when there are enough comparable businesses being sold to create a reliable valuation. In other words, if you own a coffee shop or hair salon, you should have no problem creating a valuation with the market approach. If you own a business that sells cheese made out of yak’s milk, this might not be the approach for you.

    Also, the drawback to the market approach valuation is just because a business sells the same product or service doesn’t mean it’s going to have the same success. There are a lot of intangible factors that give a business success, such as leadership and branding. All of the business valuations involve assumptions and risks; it’s an attempt at quantifying the unquantifiable.
  2. Valuation Income Approach
    Now let’s say that you’re selling your business to someone else. You’re leaving the game, but your business is alive and well and could make someone else money. Its ability to produce cash makes it so much more valuable than just the price tag on the equipment the business owns. Maybe you have a real unique thing going, and no other businesses like yours have ever been sold. In these cases, you’d use the income approach to reach a valuation of your business. The income approach utilized income statements to determine the earning power of your company in the future. When you’re selling your business or gathering investors, telling them you have $150 worth of equipment and you work out of your garage on nights and weekends lacks much appeal. However, telling them that your business valuation predicts that you’ll earn $1 million in the next 12 months gets them listening.

    The risk with income approach valuations is that the estimated future earnings are just estimations. Maybe much of your business comes from clients who are loyal to you and wouldn’t be as loyal to a new owner. If you sold your business to someone else, they might not see the estimated valuation that your past income statements suggest they would. That taken into account, the income approach is a reliable way to represent the value of a business.
  3. Valuation Asset Approach

    Now, in our third scenario, let’s say your business has had a successful run but you’re ready to close up shop and start a new chapter in life. You might have some debts, but you also own some equipment and have some cash in the bank. The asset approach calculates the market value of the assets less the debts your business owns to determine the total value of your company.

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