The Most Common Business Valuation Methods

Business Valuation Methods: When finding the value of a business, there are three primary methods used by valuation experts.  Those three methods are: Discounted Cash Flow, Market Approach, and Cost Approach.  These are the main methods used by investment bankers, M&A firms, leveraged buyouts and financial planning.  The diagram below shows the three methods.

Business Valuation Methods Chart

When figuring out business value, each of the methods is unique:

  • The most common method is Discounted Cash Flow method. With this approach, the intrinsic or expected value of the future income is calculated over 10 years and discounted for risk and return requirements.
  • The Market Approach relies on readily available information on sales of similar businesses. This approach is more common for public companies or companies who have transaction data for the industry.
  • The Asset-Based Approach examines the total market value of assets minus liabilities.  This method is not typically used for purchase, but does establish a base for the value of the business.

Method 1: Discounted Cash Flow

When data for similar businesses aren’t available, the Discounted Cash Flow is the most common method of business valuation.  Often, Valuation using the Discounted Cash Flow method requires an analysis of past, current, and future business cash flow.  Cash flow is different from profit in that it examines timing of flow of funds and non-cash expenses (like interest and depreciation).  This method also takes a buyer’s cost of capital into consideration.

When performing the Discounted Cash Flow analysis, it is important to build a financial model in a spreadsheet software.  This approach involves the most assumptions and typically produces the highest business value.  Because assumptions are involved, the more accurate the data, the more reliable the valuation will be.  Once the model is built, several different scenarios can be tested.  These scenarios could include different revenue or profit growth rates or impacts of certain threats to the business.  See below for a simple Discounted Cash Flow example.  This Discounted Cash Flow Method Template is available in Google Docs.

Discounted Cashflow Valuation Method Example

For larger businesses with multiple divisions, this method can be very complicated.  Luckily, for larger businesses, there is typically more sale data readily available.  In this case, the Market Approach is preferred.

Method 2: Market Approach

Previous Transactions

The Market Approach using previous transaction relies on transaction data from the sale of similar businesses.  This approach provides a relative value by comparing the business to others which have recently been sold. 

It is important to use comparable businesses in similar industries and of similar sizes.  This is done by comparing sales price against revenue, EBITDA, EBIT, and other ratios.  Multiple of EBITDA is used most frequently, but including other figures can provide a more accurate picture.

The “comp” approach is similar to finding value of real estate using comps of similar properties recently sold.  By observing the sales price of other companies, a reasonable assumption can be found for the business in question.  For mid-sized businesses, this is the most common valuation method as it is simple to compute by M&A firms.  An example is below and the Previous Transaction Template is available in Google Docs.

Previous Transaction Method Example

For larger businesses with multiple divisions, this method can be very complicated.  Luckily, for larger businesses, there is typically more sale data readily available.  In this case, the Market Approach is preferred.

Comparable Analysis

The Market Approach using comparable values (also known as “peer group analysis” or “equity comps”) is used to estimate business value of large, public companies.  This method relies on publicly available financial data to compute the current value of similar busineses.  Because this data is readily available, the analysis can compute current value (“enterprise value”).  This value can then be analyzed against Sales, EBITDA, Earnings to compute ratios.  These average of these ratios can then be computed and used to calculate the value of the business in question.

See below for an example. An example is below and the Comparable Analysis Template is available in Google Docs.

Method 3: Asset-Based Valuation Approach

The Asset-Based Valuation Approach estimates costs required to duplicate the current business.  This valuation method is useful for computing the asset price allocation.  This method identifies all company assets and their market value and lists them on a spreadsheet.  Then all the market value of all assets is added up and liabilities are subtracted off. 

This method examines the market values of business assets compared to liabilities of the business.  The difference between the two is the business value.  This method is different from simply looking at the balance sheet as it takes market value into consideration and not book value. 

This method also accounts for off-balance sheet assets such as intangible assets.  It also accounts for any contingent liabilities such as pending lawsuits or cost from regulation compliance.

Other Valuation Methods

Cost Approach: This method is used to find what it would cost to re-build the business.  This is not typically used in corporate finance.  This method often disregards “goodwill” and value of future cashflows.

Ability to Pay Approach: This method examines a purchase price a buyer can pay and still hit certain return goals.  For example, if a private equity firms requires a 35% return, it can calculate the maximum price is would be willing to pay for a business.

Liquidation value:  Sometimes it is helpful to know the value of the company’s part.  This is found by estimating the value of sectors or division as standalone assets.  This value is typically much lower than other valuation methods.

More Valuation Resources

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