Business Valuation: Definition and How To Calculate
By Indeed Editorial Team
Updated December 30, 2021 | Published February 4, 2020
Updated December 30, 2021
Published February 4, 2020
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
When a business is being sold, whether for its liquid assets or to continue operations under new management, it's crucial for both buyer and seller to have a fairly accurate idea of what the business is worth. Business valuation is done using one or a combination of several different methods to determine the business's monetary worth, taking into consideration the business's debts, assets and liabilities. This article will aim to explain the methods of business valuation and list a few jobs that use valuation methods.
What is business valuation?
Business valuation is a set of methods to determine how much your business is worth. These calculations include the following values:
Other factors you might consider include your projected earnings, management structure, share price and more. Business valuation methods are necessary for several reasons. One may be that you're selling your business, or you're trying to get a business loan or bring investors on board. The valuation method that is best for your situation is typically dependent upon why the valuation is needed, your industry, the size of your business and other facets.
For example: If you're selling your small business, you'll likely sell it for its assets. In this situation, you will need to know the collective value of your business assets to come to a fair asking price. This method is done by brokers hired by both the buyer and the seller to get the most objective figure.
In addition to determining the monetary value of a business, business appraisers often use valuation tools to help resolve monetary disputes related to divorce settlements, estimating value shares in the business (in a partnership), estate and gift taxation and other purposes. In litigious cases, the court will likely appoint an objective forensic accountant to perform the valuation. Valuation is also used in tax reporting. The IRS requires businesses to be valued based on their individual fair market value. Taxes on a sale, purchase or gifting of company shares are taxed depending on valuation.
Business valuation methods
There are many ways a business value can be established, including:
The market value formula establishes the value of a business by comparing it to similar businesses in the area that have recently sold. This method requires businesses to access sufficient market data on their competitors, which can be challenging for sole proprietors because the data isn't made public and as such, is difficult to find. This method is relatively imprecise and often ends up being based upon negotiable factors. That said, it may be a helpful preliminary approach to gaining an understanding of what your business may be worth, but due to its relative unreliability, you may not want to use this method alone.
Related: Why Market Value Is Important
These methods are based on the equity of your business by determining the difference in value between assets and total liabilities according to the business' balance sheet. There are two main approaches to asset-based valuation:
Going concern. This is the non-liquid method in which a business that will not be liquidated — but instead kept in running operation — will have none of its assets sold off immediately.
Liquidation value. The liquidation method is based on the assumption that the business will be immediately liquidated. The net value equals the amount that would be paid if the business ceased operations and its assets sold (at a reduced value, because liquid value is far less than fair market).
This method is based on simple math: The amount desired divided by the percentage offered equals 100% BV. For example, if you ask for $250,000 in exchange for 25% of your business, then you're valuing your business at $1 million. If you're using this approach to seek investors or buyers, you'll need to convince them that your valuation is true. Put yourself in the position of the investor or buyer, and ask yourself the following questions:
When will I recover my original investment?
What will my return be if I compare my expected net income to my investment?
How realistic is that estimate? Based on this, do I want to invest in this company?
Discounted cash flow (the income approach)
This method values a business based on its expected cash flow, adjusted for its present value.
Capitalization of cash flow
This method is most often used when a company's projected levels of growth are expected to remain relatively stable in the future. The method essentially assumes a single benefit stream will grow at a steady rate forever. This method is typically applied when valuing established companies with limited future growth expectations.
Discounted cash flow
This method allows for variations in marginal growth, accounts payable and other items in the future. This method is often used when future growth rates are expected to fluctuate, or when modeling the impact of accounts payable payments going forward.
Capitalization of earnings
This method's calculations are based on the business' expected future profitability, which is determined by taking into account its cash flow, annual ROI and expected value. This method works best for established businesses, as the formula assumes that returns for a duration of time will continue.
Multiples of earnings (times revenue method)
This method assigns a maximum worth by assigning a (variable) multiplier to a business' current revenue. Multipliers differ according to industry, current economy and other considerations.
This method is largely the same as an asset-based method in that it figures the value of the business' equity as total assets minus total liabilities per the business' balance sheet.
Market capitalization is simply calculated by multiplying the company's share price by its total number of shares outstanding.
Jobs that use business valuation
For the most up-to-date salary information from Indeed, click on the national average salary link for each job title below.
National average salary: $54,513 per year
Primary duties: An accountant ensures operational efficiency through monitoring financial records and analyzing data related to finance reports, budgets, tax returns and accounting records. Responsibilities typically include:
Recording financial transactions
Periodically (monthly, quarterly, annually) reconciling bank and credit card statements, annual auditing and providing financial reporting support as necessary
Analyzing and reporting on income statement variances, preparing budgets and communicating financial analysis results to management
Making financial recommendations after identifying and analyzing available options
Using analytical and critical thinking skills to correct and improve systems and procedures
Providing support in tax preparation and reconciliation
Education requirements: To be an accountant, a bachelor's degree in accounting, finance or related field is required, though many employers prefer their accountants to have earned a master's degree as well as a Certified Public Accountant designation.
National average salary: $86,933 per year
Primary duties: A person in this role analyzes and supervises a business' financial reporting processes. All accounting practices within an organization are overseen by the controller, who may then make recommendations regarding financial and budget practices to the company's decision-makers. This role also performs the following:
Prepares financial statements, budgets and reports
Monitors trends in the company's finances and makes recommendations
Manages budgeting and looks for ways to cut costs
Approves invoices for payment
Recruits financial analysts
Education requirements: A financial controller must have at least a bachelor's degree, but preferably a master's, in a relevant field like finance, accounting, economics and business systems.
National average salary: $133,898 per year
Primary duties: A chief financial officer directs annual and long-term financial goals of an organization. This role is responsible for performing overarching business and accounting tasks as well as ensuring accuracy and regulatory compliance of financial reporting. Some other responsibilities for this role include:
Ensuring full transparency over the organization's financial performance
Developing strategies to increase company revenue and reduce costs
Overseeing mergers and acquisitions
Preparing and presenting monthly and annual financial plans
Supervising the preparation of financial statements and tax documentation
Education requirements: A CFO is expected to have earned at least a bachelor's degree in accounting or finance, though some companies will require the person in this position to hold an MBA.
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