1. Money

3 Business Valuation Methods

How to Determine What Your Business Is Worth

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How much your business is worth depends on many factors, from the current state of the economy through your business’s balance sheet.

Let me say up front that I do not believe that business owners should do their own business valuation. This is too much like asking a mother how talented her child is. Neither the business owner nor the mother has the necessary distance to step back and answer the question objectively.

So to ensure that you set and get the best price when you're selling a business, I recommend getting a business valuation done by a professional, such as a Chartered Business Valuator (CBV). In Canada, you can find Business Valuators through the yellow pages or through the website of the Canadian Institute of Chartered Business Valuators.

A Business Valuator (or anyone valuating your business) will use a variety of business valuation methods to determine a fair price for your business, such as:

1) Asset-based approaches

Basically these business valuation methods total up all the investments in the business. Asset-based business valuations can be done on a going concern or on a liquidation basis.

  • A going concern asset-based approach lists the business net balance sheet value of its assets and subtracts the value of its liabilities.
  • A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off.

2) Earning value approaches

These business valuation methods are predicated on the idea that a business's true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning.

With this approach, a valuator determines an expected level of cash flow for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.

Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.

What might such capitalization rates be? In a Management Issues paper discussing "How Much Is Your Business Worth?", Grant Thornton LLP suggests:

"Well established businesses with a history of strong earnings and good market share might often trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalization rates, say 25% to 50%."

3) Market value approaches

Market value approaches to business valuation attempt to establish the value of your business by comparing your business to similar businesses that have recently sold. Obviously, this method is only going to work well if there are a sufficient number of similar businesses to compare.

Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price.

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