Valuation methods are a set of tools that help you understand how much your entire business is worth. Depending on the size of your business, be it an established company, a small business, or a startup, there are a variety of valuation methods to match the scale of your enterprise. Although getting a complete idea of your business valuation can seem daunting, it doesn’t need to be. Read on to learn what the best valuation methods are for your business, and how you might apply them.
What Is A Business Valuation?
A business valuation looks at every area of your company and assesses its individual and collective economic value. Such areas include:
- Projected earnings
- Liquid assets
- Share price
- Occasionally, intangible assets such as brand recognition and customer retention rates
Why Do You Need A Business Valuation?
A business valuation takes place for a variety of reasons. Some of the more common factors include: If you are looking to sell your business, or merge with, or complete a business acquisition. Here, you need to ascertain that you are selling your business for a price reflective of its current value.
Business valuation methods might also be used as a means of attracting new investors, business financing options, or calculating fair partner ownership percentages. Alternatively, if you are a buyer looking to purchase a business, you want to be sure that the right valuation methods have been used to assess a prospective company fairly.
To get an idea of how different valuation methods work, we’ll look at how they are applied to enterprises of various sizes. From large to small, we’ll begin with company valuation methods, working our way through to medium-sized business, small business, and finishing with startup valuation methods. Then, we’ll round up the article by looking at a series of inventory valuation methods that are applicable regardless of company size.
Company valuation methods
An established large-sized enterprise can utilize a variety of company valuation methods. Two popular approaches, however, are the asset-based valuation method and the capitalization of earnings valuation method. Let’s explore these further:
The asset-based valuation method
This valuation method takes into account the company’s total net asset value and equates that with its overall worth. Dependent on whether the company is going to continue or cease operations after its appraisal, there are two different asset-based valuation methods to consider:
- The going concern
This approach is for companies who are going to continue their operations, and thus keep all of their assets after the valuation process. The going concern assesses a company’s total net asset value and subtracts its total liabilities to get a comprehensive current total equity figure. This figure is also sometimes referred to as a company’s ‘book value.’ Book value is an advantageous approach for any company that doesn’t have a lot of profit, but that owns many valuable assets.
- Liquidation value
This company valuation method is appropriate for any company that will cease operations by selling all of its assets after the appraisal. Its value is based on the net amount of money that would be amassed if the company was liquidated and all of the assets were sold. However, it is essential to note that the value of the assets is likely to be considerably lower than the market price as they will be sold having already been used.
An asset-based method of valuation is only suitable for larger businesses or companies which have amassed significant assets. For sole proprietors, this approach is more complicated because all business assets exist in their name, making separating the personal from the business assets more challenging.
For example, a sole proprietor running a mobile phone store may own several smartphones for business and personal use, making it challenging for a prospective buyer to identify which assets will be included in the business sale.
Capitalization of earnings valuation method
The capitalization of earnings valuation method looks at a company’s past earnings (cash flow and ROI) record of predicting its future earnings. It adjusts and normalizes its recent earnings for any unusual expenses, multiplies it by a capitalization factor (a metric that reflects the measure of risk and is computed as the inverse of the expected rate of return) , and determines a predicted future cash flow. This method is particularly suited to established companies as they have a sizable amount of past earning data, making it easier to forecast future earnings.
Medium-sized business valuation methods
The market value valuation method appraises the value of other similar businesses on the market and looks at how much they sold for. This method can give you a clearer idea of how much your business will be worth. The idea is that if you are selling a particular type of business, you will research what owners are demanding for similar businesses.
However, this approach only works if there are enough similar businesses in the market to compare yourself to. If comparable competition is scarce, consider using this approach as a solid basis for getting a basic estimate for what your business could be worth, before applying a range of different valuation methods to get a clearer idea.
ROI-based (return on investment) valuation method
This approach values your business in accordance with the potential ROI it could generate for a prospective investor. To get your ROI figure, you divide the portion of the company you’re selling by the percentage that the investor wants to buy. For instance, if you’re asking $300,000 in exchange for 30% of your business, you will divide the figure by the percentage offered. To keep investors happy with this valuation approach, you also need to be able to tell them how long you expect it to be until they can receive a return on their investment.
Both the market value and the ROI-based valuation methods are inherently subjective and rely on the market, which is in a constant state of flux. If you decide to opt for either of these approaches, do so in combination with at least one other method, preferably a more objective one to give yourself a more substantial sense of your business’ value.
Small business valuation methods
As they often lack a substantial net asset value, and may not be as profitable as more established businesses, it’s trickier to value small businesses—but not impossible. Frequently, the value of a small business may be dependent on how much a buyer is willing to pay for it, and what’s driving them to do so in the first place.
Yet, what they lack in tangible current worth, they can often make up for in terms of future profitability. Let’s look at four small business valuation methods that cater to this phenomenon.
The entry cost valuation method
This valuation approach takes into account all of the costs of setting up a similar small business to the one being valued to get an idea of its net worth. Such factors to be considered would include:
- Purchasing all the required assets
- Costs associated with developing the products and services
- Recruiting and training employees
- Establishing a customer base
- Building a reputation
- Purchasing any necessary licenses
Once added up, all of these components create a reliable estimate for the small business valuation.
The multiple earnings method
This method uses a formula to ascertain the value of a business. The formula is as follows: Business’ net profit x the multiple of its sector = the valuation figure. Accountants will usually supply you with a ‘multiple’ that’s relevant for your business by your industry and the size of your enterprise. The higher the multiple you are provided, the greater the value of your business.
Several factors can increase your business’ multiple, in ascending order, they include:
- If the company does not depend on a single owner to operate
- If it boasts a unique means of operating which distinguishes it from the competition
- If it can bring multiple new products to market
- If it can forge new distribution channels
- If it can create a strong brand
- If it is scalable and the business can be rolled out nationally or internationally
The seller’s discretionary earnings valuation method
The Seller’s Discretionary Earnings (SDE) valuation method values a business based on how much income its owner can expect to generate from the company each year. Calculating SDE requires you to determine how much cash is required to run your business operations.
First, use your financial statements to get your business’s earnings before interest and taxes (EBIT), then add back your compensation and benefits like health insurance. Also, add back those personal and discretionary expenditures that are not related to your business’s operations but are necessary to adjust your SDE. These may include travel expenses, office rent, and the use of a personal vehicle.
When it comes to valuing your business, you’re going to apply a multiple to your SDE. The multiple can be 1, 2, or even 4, depending on the purchaser’s need to receive compensation for the amount of effort needed to run the new business.
The rules of thumb valuation method
This valuation method applies to sectors where the sale and purchase of businesses is a common practice. It looks at other things besides profits to determine the value of a business. Let’s consider ecommerce – the rules of thumb in this sector will be factors like business revenue, inventory value, email list, etc. Every industry has certain rules of thumb that you can use as a benchmark to value for your business.
Startup valuation methods
Many entrepreneurs struggle when they have to value their startup to prospective investors, especially if they lack stable revenues, earnings, or cash flow. There are, however, two solutions to valuing a startup beyond financial factors. These startup valuation methods include the discounted cash flow (DCF) method, the Berkus method, the scorecard method, and the customer-based valuation method:
The discounted cash flow (DCF) valuation method
This approach uses a startup’s forecasted cash flow, which has been adjusted to reflect its current value. To reach this figure, however, a meticulous methodology is required. Here’s how to implement this startup valuation method:
- Estimate the total market and potential growth for the startup’s product or service
- Predict what the market share acquisition may look like over time
- Identify the startup’s fixed and variable costs and forecast its future working capital and expenditures.
- Arrive at a discounted cash flow figure
It’s important to note that, as most startups fail, a discount rate will need to be applied to these forecasts to accommodate for the risk inherent in them. The discount rate can be determined by assessing at which stage of its lifecycle the startup is in currently.
The Berkus valuation method
Introduced by American angel investor and venture capitalist Dave Berkus, the Berkus valuation method values a startup based on a comprehensive assessment of the following success factors:
- Sound idea
- Quality management team
- Strategic relationships
- Product rollout and consequent sales
You can give a rating up to $500.00 to each factor, so the highest possible valuation is $2.5 million.
The Berkus valuation method is a basic estimation that’s often used to gauge the value of technology startups. However, it doesn’t take the market potential into consideration, so it may not be the best way to value your startup from a buyer’s perspective.
The scorecard valuation method
Also referred to as the Bill Payne valuation method, the scorecard approach to valuing a startup works by comparing it to other startups that are already funded. To start, you figure out the average valuation of pre-revenue startups in your industry. Once done, you can determine how your startup compares to others in the same sector by accessing the factors below:
- Strength of the management team (0-30 percent)
- Size of the potential market (0-25 percent)
- Product idea or technology (0-15 percent)
- Competitive environment (0-10 percent)
- Marketing partnerships or sales channels (0-10 percent)
- Need for additional investment (0-5 percent)
- Other factors (0-5 percent)
The last step is to assign a score to each of the above factors based on your startup’s standing and then multiply the sum by the average pre-money valuation of comparable funded startups. However, keep in mind that ranking the factors is a very subjective process, and you could end up overvaluing your startup if you’re not careful.
Customer-based corporate valuation method
This novel valuation method is one that’s particularly beneficial for startups because it uses customer acquisition and retention rates as the basis of valuation. By using specific, predictive software, startups can see how well they are acquiring, retaining, and monetizing their existing customers.
This valuation method can either be used on its own, or it can be combined with a more traditional valuation method as it helps give startups a more accurate picture of their current overall value, especially if profitability is scarce at present.
Inventory valuation methods
Regardless of the size of your business, these three inventory valuation methods can prove useful in establishing how much you’ve spent on acquiring and storing your supplies, as well as helping you to work out the value of your cost of goods sold (COGS). However, it is important to note that while the inventory value impacts your balance sheet, your COGS value impacts your profit and loss statement.
1. First-in-first-out (FIFO)
The FIFO valuation method assumes that the first products to enter your inventory will also be the first ones to be sold. While this doesn’t have to happen literally, this approach imagines that this is the way the business has operated. Each time a new item enters the inventory, it must be noted, along with its cost, and placed in the selling queue. When a product is sold, the price must be recorded. Once you have a buying and a selling price for each item of stock, you can work out the FIFO inventory valuation method.
Here’s an example of how to do it:
- Imagine that in August, you order 20 t-shirts for $5 each
- In September, you order 30 t-shirts for $10 each
- If you sell 30 t-shirts at the end of September, according to FIFO, you need to calculate your inventory costs systematically
- So, working chronologically, from those 30 t-shirts you sold, the first 20 came from the $5 T-shirts bought in August, and the next ten came from the $10 T-shirts bought in September
- Consequently, the cost of goods sold according to FIFO would be $200 ($100 + $100)
2. Last-in-first-out (LIFO)
The LIFO approach is the opposite of the FIFO method. Here, you base the value of your inventory on the idea that the last items to enter your inventory will be the first ones you sell. You can use LIFO as a way of reducing taxable income and is only accepted as an inventory valuation method in the US under the GAAP rules.
Using the same figures from the example above, here’s how LIFO looks in action:
- If you sell 30 T-shirts at the end of September, then according to LIFO, you need to calculate your inventory costs from the most recent product to enter your inventory.
- So, from those 30 T-shirts, all 30 would come from the order you made in September of 30 T-shirts costing $10 each.
- So, your cost of goods sold, according to LIFO, would be $300.
3. Weighted Average Cost (WAC or AVCO)
In contrast to FIFO and LIFO, the WAV inventory valuation method uses an overall average for both the buying and selling price to arrive at the inventory’s value. This valuation method works according to the following:
- Work out the average buying price for your inventory items. This means looking at the total amount of money you paid for your inventory items over the year and dividing it by the total annual number of items in your inventory.
- Work out the average selling price by dividing the total revenue for the year by the number of sales that were made.
However, the WAC valuation method doesn’t accommodate for significant price fluctuations within the inventory stock or if a new product enters the inventory.
Valuation Methods Summary
No matter whether your business is large or small, a startup, or an established company, there are a host of valuation methods that you can use to get an informed picture of your enterprises’ worth: For the larger companies, we consider the asset-based valuation method and the capitalization of earnings method. For the medium-sized businesses, we looked at the market value valuation method and the ROI-based valuation method. For smaller businesses, the entry cost valuation method,the multiple earnings method, the seller’s discretionary earnings method, and the rules of thumb valuation method were discussed. As For startups, we examined the discounted flow valuation method, the Berkus valuation method, the scorecard valuation method, and the customer-based valuation method. And finally for all businesses, large or small, we provided three different inventory valuation methods to help you get a better grasp of your overall inventory costs and the cost of goods sold.
Is there a valuation method you find helpful that isn’t included in this article? Let us know in the comments below!