You can't put a price on the satisfaction you get from owning a business. But the time may come when you need to put a price on the business itself.
Read on to learn when and how to measure the value of a business.
What is business value?
Business value is an estimate of the worth of a business. You can think of it as an assessment of the financial and non-financial health of a business. As you can imagine, the business valuation is subjective. It factors in the financial metrics of a business. These include assets, revenues, price-to-earnings ratio and cash flow.
But business value also considers non-financial metrics. These include the market value of the business.
When do you need to quantify the success a business?
Many scenarios arise when you may need to determine the valuation of a business:
- Intent of buying a business. Knowing the business's value can help you avoid overpaying for an underperforming business. By the same token, you'll be less likely to underbid on a high-value business.
- Thinking of selling your business. On the flip side, you'll be less likely to sell your venture to a low bidder if you know how to value a business. You'll also know to give it a fair starting price if its value is less than you anticipated.
- You need funding. Knowing how to value a business can go far in proving its worth to investors. This applies whether you're looking for startup capital or a new round of funding. An investor is unlikely to make a blind investment in an unknown business.
- You need a loan. The value of your business can help a bank assess your creditworthiness. You want to prove to banks that you're not a high-risk borrower. It's hard to make that claim without having the cold, hard financial facts about your business.
How to value a business
Below are five methods you can use to estimate the value of a business:
- Asset-based valuation. One way to gauge economic value is to add up the assets and inventory and subtract liabilities. Assets include tangibles like land, buildings and equipment. They also include intangibles like patents and copyrights. Liabilities include loans or bonds payable. Any business on top of its books can derive this information from a recent balance sheet.
- Revenue-based valuation. Determine how much revenue a business pulls in on an annual basis. Then, estimate the company's value as a multiple of this figure. It's common for a business to sell for one to two times its annual revenue.
- Capitalization of earnings. This method determines a business's worth based on the price-to-earnings (P/E) ratio. The P/E ratio is the relationship between a business's current share price and its earnings per share. Let's say a business has a P/E ratio of 16 and projects $100,000 in net annual earnings. A reasonable valuation of the business would be $1.6 million.
- Discounted cash-flow analysis. This method uses future business cash flows, discounted by the cost of capital, to get a current value. The present value is an income stream's value at the time of its valuation. You can then use that number to assess the investment potential of a business. Online NPV calculators make it easy to complete a discounted cash-flow analysis.
- Value-based analysis. A business is more than its financial statements. This is why it's helpful to think outside the realm of financial stats when you assess its value. You should also, for example, factor in the price at which competing businesses in the area sold. Remember to consider relationships that add value. For example, your employee, customer, or supplier base can all add to the worth to the final figure.