Whether you’re buying a business or selling a business, you have to know what the business is worth. A third-party business valuation is how you can be sure the asking price is fair.
There are multiple ways to value a business, and the method you use could affect the number you arrive at. It depends on factors like why the valuation is needed, the size of the business, and the industry.
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Most business valuations are based on four standard methods: asset-based, earning value-based, market value-based, and ROI-based.
An asset-based business valuation values your business based on what it owns. Equipment, real estate, website URLs – anything you could sell is an asset.
The asset accumulation approach subtracts your liabilities (what you owe) from your assets (what you own). The amount left over is your asset-based value.
This is also known as the liquidation approach. It figures what the net value would be if the business sold off everything it owned and paid off all its debts.
The excess earnings approach takes into account your business’s intangible value.
Tangible assets are physical things like real estate, equipment, and inventory. Intangible assets can’t be held in your hand. They include things like your business’s reputation, intellectual property, and brand recognition.
The second standard method of business valuation assumes a business’s true value is its potential for future earnings. Instead of tallying up what you own today, it looks at what you could be expected to earn tomorrow.
The past-earnings approach estimates cash flow based on past revenue. This tells you the rate of return and level of risk the average buyer could expect from this business.
Instead of looking at historical revenue data, the future-earnings approach estimates potential revenue. It uses market trends to calculate what the business will be worth in the future.
The first two standard methods of business valuation are focused inside the company. The third method turns that gaze outward.
A market value approach compares the business to similar businesses that have recently sold. It estimates the business value based on market demand.
As a standalone method, this can be tricky. There have to be enough similar businesses on the market to get a solid estimate. It’s usually combined with another valuation method.
Return on investment is a quick, easy way to calculate the rough value of a business. This is a great starting point to kick off a conversation between a buyer and a seller. It should not be used when it comes to setting an actual asking price, though.
Return on investment is calculated by dividing the dollar amount offered by the percent share of the business.
If you offer $500,000 for a 50% share in a business, you are valuing the business at $1 million.
ROI valuations are quick and dirty – which is why they shouldn’t be used to make a formal offer. Without the level of data the other valuation methods use, you have no idea if you are over- or undervaluing the business.
No one method is actually better than another. Each one performs best in different circumstances. Most businesses are valued using a combination of approaches.
Valuing a young online business with a single revenue stream requires a very different approach from valuing a longstanding brick-and-mortar business with multiple products.
Both buyers and sellers should be comfortable with how the business was valued. If you don’t understand where the number for the valuation came from, you can’t decide if it is a fair price.
The best way to make sure you are asking or offering a fair price is to get the advice of a professional business broker. We can help you understand how the other side arrived at their number and if it’s a good or bad deal for you.
