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What is a Business Valuation?

What is a Business Valuation?

Business valuation is a common process of determining the economic value of an entire company or business unit. Business valuation can be used to ascertain the fair value of a business for a variety of reasons, including the value of sales, determining partner ownership, taxes, and even divorce proceedings. Owners often turn to professional appraisers to estimate the business's value objectively.


The basics of business valuation

The subject of business valuation is often discussed in corporate finance. Business valuation is usually done when a business wants to sell all or part of its business or wants to merge or acquire another business. Business valuation is the act of determining the current value of a business, using objective measurements, and evaluating all aspects of the business.

A business valuation may include an analysis of the company's management, its capital structure, prospects for future earnings, or its market value of its assets. The tools used for assessment may vary between assessors, companies, and industries. Common approaches to business valuation include but are not limited to a review of financial statements, updating cash flow models, and comparisons between similar businesses.

The valuation is also vital for tax reporting. The IRS requires that a business be valued at its fair market value. Certain tax events, such as the sale, purchase, or gift of shares of a company, will be subject to assessment-based taxation. 

Estimating the fair market value of a business is both an art and a science; many formal models can be used, but choosing the right one and then the right inputs can be subjective.


Special Considerations: Valuation Methods

There are numerous ways to value a business. You will learn many of these methods below.

  • Market Capitalization: Market capitalization is the easiest way to value companies. It is calculated by multiplying its share price by the total number of outstanding shares. For example, on January 3, 2018, Microsoft Inc. was trading at $86.35 with total shares outstanding amount of $7.715 billion; the company could be valued at 86.35 x $7.715 billion = $666.19 billion.

  • Times Revenue Method: With the times revenue method, a stream of revenue generated over a period of time is applied to a multiplier that depends on the industry and economic environment. For instance, a tech company may be valued at three times its revenue, while a service company may be valued at 0.5 times its revenue.

  • Earnings Multiplier: Instead of the times revenue method, the earnings multiplier can be used to get a more accurate picture of a company's true value because a company's profits are a more reliable indicator of its financial success than the turnover. The earnings multiplier adjusts future earnings based on the cash flows that could be invested at the current interest rate over the same period. In other words, adjust the current P/E ratio to reflect current interest rates.

  • Discounted cash flow method (DCF): The DCF method of valuing your business is similar to the Earnings Multiplier. This method is established on the forecasts of future cash flows, which are adjusted to obtain the business's current market value. The major contrast between the discounted cash flow method and the profit multiplier method is that it takes inflation into account when calculating the present value.

  • Book Value: It is the value of a company's net assets, as shown on the balance sheet. Book value is obtained by subtracting a company's total liabilities from its total assets.

  • Liquidation Value: This is the net cash a company will receive if its assets have been liquidated and its debts are paid today.

This is by no means an all-inclusive list of business valuation methods currently in use. Other methods include breakup value, replacement value, asset-based valuation, etc.


Business Valuation Accreditation

In the United States, Accredited in Business Valuation (ABV) is a professional name given to accountants, such as CPAs, who specialize in calculating the value of businesses. Accredited in Business Valuation certification is handled by the American Institute of Chartered Accountants (AICPA) and requires candidates to complete an application process, pass an exam, meet minimum business and educational experience requirements, and pay an application fee. 

Holding ABV accreditation also requires certification holders to meet minimum standards of work experience and lifelong learning. Successful candidates gain the right to use the ABV name along with their name, which can improve job opportunities, professional reputation, and compensation. 


Summary

  • Business valuation can be used to ascertain the fair value of a business for various reasons, including sales value, partner ownership, taxes, and even divorce proceedings.

  • Business valuation establishes the economic value of a company or business unit.

  • There are numerous ways to value a company by looking at its market capitalization, earnings multipliers, or book value.


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