How to Calculate the Valuation of a Company
If it makes funding your business easier, why not?
What is company valuation?
Essentially, valuation of company refers to the formal, professional and technical process of determining a company’s or business’s value.
Due to the unpredictable nature of businesses—which can grow exponentially or become bankrupt in a matter of months—it is difficult to determine the actual economic value of a company. Hence, a company’s valuation is considered to be an indicator of a company’ worth.
Why is company valuation important?
If you are considering starting a business or are in the midst of growing yours, the valuation of a company is crucial when it comes to making both major and minor business decisions. Some instances in which your company may need a valuation include:
- Selling your business
- Selling shares in your business
- Funding your business
1. Selling your business
If you are planning on selling your business, a company valuation helps to determine the worth of your company during a strategic sale, which can highly influence negotiations.
2. Selling shares in your business
For business owners, valuation of a company allows you to be aware of the worth of your shares when you are ready to sell them, so that you are able to gain good value from them.
3. Funding your business
Raising funds to finance your business can be a difficult task. For this reason, valuation of your company can give potential investors an indication of how credible your business is, how much they should invest and the risks involved when they invest in your business.
During a court case such as a partnership or shareholder dispute, the valuation of your company can provide proof of your company’s worth, so that any damages are based on the actual worth of your business rather than inaccurate figures estimated by lawyers.
In divorce cases, if the business interest was acquired during the marriage with joint funds, it will be considered as matrimonial property, and the value will be split equally between both spouses. Conversely, if the business interest was acquired before the marriage or with separate funds, it will be considered as separate property.
Bankruptcy happens when the company’s debts exceed available cash or assets. Although it may seem counterintuitive, the bankruptcy likely has some value; physical assets can be liquidated for cash value and the firm may still have recurring cash flow despite excessive debt.
However, without proper valuation, creditors, lenders, and debtors have differing views of value.
Having a written valuation of the company provides the professional documentation that can assist with creditor negotiations and provide the basis for a financial restructuring plan.
Differences between valuation of public and private companies
There are a number of factors that are considered differently in the valuation of privately held vs. public companies—even those that are in the same industry—making a direct comparison for valuation purposes difficult.
Difference in market liquidity
The stock of public companies can be easily liquidated through stock exchange. Unlike public companies where buyers and sellers are readily available to purchase and sell shares of a company, negotiating the prices of the shares of the private company can be lengthy without a professional valuation, especially when the parties cannot agree on a value.
Difference in risk profile
Public companies are relatively more stable than smaller, private companies. Economic downturns, increased competition or even regulatory changes often have a greater impact on private companies in terms of performance and liquidity. Hence, the risk profiles of private companies are usually higher, resulting in a discount in value as compared to their public counterparts.
Difference in capital structure
Public companies within a specific industry generally maintain similar capital structures (debt-to-equity ratios). This means that the price-to-earning ratios are usually comparable and can be used to derive the valuation of another public company in the same industry.
However, private companies within the same industry can vary widely in capital structure. Hence, the valuation of a private company is often based on pre-debt figures of the business rather than the value of the stock of the business.
How to calculate valuation?
Business valuation experts often play an important role in resolving shareholder disputes by providing independent and unbiased opinions of value for the shares in question.
To ensure an objective estimate of the business, it is imperative for the analyst to conduct the valuation with careful consideration of all relevant information such as overall economic conditions and changing demand for the products or services of a business.
In general, valuation analysts use three main methods for their calculations. The analyst may also use a combination of the three methods, depending on the purpose of the valuation.
1. Asset-based approach
An analyst using this approach will determine the fair market value of the (tangible and intangible) assets, minus any related liabilities. In other words, the asset-based value is equal to the book value of the company or the equity that the shareholders hold. An asset-based business valuation can offer flexibility to quantify intangible assets, such as trademarks, which may or may not be reflected on the balance sheet.
2. Income-based approach
This method relies on the income the business generates. Typically, a weighted average of recent historical data is adjusted to result in a stream of cash flows that the business would receive over a time period. This stream of cash flows is then discounted to its present value.
3. Market approach
With a market approach, a valuation analyst will determine the value of the business by looking at the market value of comparable assets or businesses in the similar industry. For instance, in order to determine the value of the company shares, the recent selling price of the shares of other similar businesses will be taken into account to provide a good estimation of the fair value for the business under valuation.
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