What is a business valuation?

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A business valuation is a process whereby a value is placed on a business or a business unit, based on the historical and projected financial performance of the business.  It is critical, as a shareholder or business owner, to know what your business is worth in order to make sound business decisions and maintain ongoing business strategy. These decisions can include evaluating or negotiating a possible sale of the business (or a portion thereof), or the planning of a business restructuring by merging into an existing business or acquiring another.

The business valuation will also help raise capital when negotiating with potential investors and financial institutions for funding. Business worth is a very important consideration for individuals with interest in such businesses, especially in the planning of an estate, in the event of marital dissolution or when taking on a buy-and-sell agreement to ensure business continuity.

The valuation of a business unit is a complex affair and there are different methods that can be used to value a business. The most commonly used methods include the following:

  1. Discounted cash flow – The discounted cash flow is calculated by using the expected future cash flows of the business and taking into account the risk that will materialise with these earnings. The future cash flows are adjusted to reflect sustainable cash flows and are discounted to the valuation date by using the weighted average cost of capital rate – this is the most commonly used method. All sources of capital are included in the calculation of this discount rate and reflect the rate that the business is expected to pay on average to its shareholders to finance its assets.
  2. Earnings multiple – The earnings multiple is calculated by multiplying the sustainable earnings of the business with a ratio that is comparable to other similar businesses in the same industry. The ratio is calculated by using actual financial results of comparable businesses.
  3. Book value – The book value is calculated by subtracting the liabilities from the assets of the business. This method is used for companies with low profits and high asset values and is usually not a good method to use for start-up businesses and businesses that experience high growth. It is also important to remember that it can be a costly exercise to revalue assets which are accounted for at the cost model, in order to calculate an accurate book value.

Valuation professionals usually calculate the value of a business by using two or more valuation methods. Although the earnings multiple is a good method to use when comparable industry information is available, it remains a challenge to gather reliable financial information on businesses that are private companies and operate in the same industries. This method is therefore only used for businesses where reliable market information exists. Although the discounted cash flow is a complex method of valuation, it is widely used by valuation professionals where reliable accounting records are available. The book value is normally the last resort when calculating the value of a business and is a good test for a valuation that was based on another method.

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice. Errors and omissions excepted (E&OE)

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