Business Valuation Explained: three methods of business valuation
As a practical matter, a business is worth what someone else will pay for the business. No more, and no less. Accordingly, no formula, rule of thumb or clever financial theory can produce a business valuation estimate that is as real or meaningful as a buyer offering to purchase a business. However, that said, business valuation formulas often follow one of the following three methods:
business valuation based liquidation value
One common business valuation method is to look at the liquidation proceeds that would stem from selling off the firm's assets, using those proceeds to pay down any of the firm's liabilities, and then counting as the business valuation whatever the leftover amount equals.
Example of "liquidation-style" business valuation:
Suppose that a small retailer has only one asset--inventory that can be sold for $100,000. Further suppose that the retailer has $50,000 of outstanding debts. A business valuation based on liquidation might say that the business is worth $50,000 because that's the cash that will be leftover after selling off the assets and paying down the debts.
A business valuation based on liquidation is often relatively straight-forward to calculate. Liquidation values for assets are often fairly easy to determine. And the pay-off amounts for the outstanding debts can often be calculated with precision simply by looking at the business's financial records. Those are the "good parts" of a liquidation-style business valuation.
A business valuation based on liquidation suffers from a weakness if a business will be operated in the future, however. Often a business, if operated in the future, has value because a new owner will benefit from the old owner's established customer base, the old business's goodwill, and so forth. These intangible assets often can't be liquidated... yet they often do have significant value.
business valuation based on rule of thumb
Another common business valuation method is to use a rule of thumb. A rule of thumb is usually a simple formula that estimates the valuation of a business through calculation. Here are some examples of actual rules of thumb:
fast food franchise: 50% of annual sales
heating, ventilation & air conditioning contractors: 2 times cash profits
mail order business: 50% of annual sales + inventory
motel: $20,000 times number of rooms
Example of "rule-of-thumb-style" business valuation:
Suppose a fast food franchise does $1,000,000 in revenue. Because the fast food franchise rule of thumb says a franchise is worth 50% of its annual sales, this example business would be worth $500,000.
A business valuation based on a rule of thumb is also usually straight-forward to calculate. The rule of thumb formulas are always very simple and based on well-known and well-understood inputs.
A business valuation based on rule of thumb, however, suffers in that the rule of thumb assumes every business is the same. The rule of thumb makes no allowance for differences between businesses in a category. Even a factor as basic and obvious as growth (or decline) in the business is ignored by a rule of thumb.
business valuation based on discounted cash flow analysis
The most sophisticated business valuation method relies on discounted cash flow analysis. Discounted cash flow analysis business valuation calculates a cash flow forecast for the business (usually for at least five years and sometimes for as long as fifty years). This cash flow stream is then discounted by dividing each year's cash flow by the following factor: (1+discount rate)^year number.
Example of "discounted-cash-flow-style" business valuation:
Discounted cash flow analysis quickly becomes very complicated as you can guess from the preceding formula. As a practical matter, you need a computer and a spreadsheet program to perform this type of business valuation. However, as just a simple example, suppose that one wants to value a business that will only operate for two years. In the first year, the business will earn $125,000 in cash flows. In the second year, the business will earn $156,250. If the appropriate discount rate to use in the discounted cash flow business valuation formulas is 25%, one calculates the business valuation of this business using the following formula:
business valuation = $125,000/(1.25)+$156,250(/1.25)^2
If you work out the math, you get the result $200,000, meaning that this business is worth $200,000 -- at least using the third business valuation method.
A business valuation based on discounted cash flows is superior to the other two business valuation methods because it looks at the firm's current and future expected profits. This business valuation method, then, doesn't assume that one business is just like any other business in its industry. And this business valuation method easily (albeit) indirectly recognizes a factor such as growth in profits. There are, however, a couple of problems with this third business valuation method. One problem is that the math scares people away from the method. Another problem is that this whole business valuation method relies on having good discount rates to use in the calculations.
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