What Is a Business Valuation?

Valuing a Company: Business Valuation Defined With 6 Methods

What Is a Business Valuation?

A business valuation, also known as a company valuation, is the process of determining the economic value of a business. During the valuation process, all areas of a business are analyzed to determine its worth and the worth of its departments or units.

A company valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings. Owners will often turn to professional business evaluators for an objective estimate of the value of the business.

Key Takeaways

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

• Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings.

• Several methods of valuing a business exist, such as looking at its market cap, earnings multipliers, or book value, among others.

Watch Now: How to Figure Out a Business Valuation

The Basics of Business Valuation

The topic of business valuation is frequently discussed in corporate finance. Business valuation is typically conducted when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business.

A business valuation might include an analysis of the company’s management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include a review of financial statements, discounting cash flow models and similar company comparisons.

Valuation is also important for tax reporting. The Internal Revenue Service (IRS) requires that a business is valued based on its fair market value. Some tax-related events such as sale, purchase or gifting of shares of a company will be taxed depending on valuation.1

Estimating the fair value of a business is an art and a science; there are several formal models that can be used, but choosing the right one and then the appropriate inputs can be somewhat subjective.

Methods of Valuation

There are numerous ways a company can be valued. You’ll learn about several of these methods below.

1. Market Capitalization

Market capitalization is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of shares outstanding. For example, as of January 3, 2018, Microsoft Inc. traded at $86.35.2 With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.

2. Times Revenue Method

Under the times revenue business valuation method, a stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.

3. Earnings Multiplier

Instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current P/E ratio to account for current interest rates.

4. Discounted Cash Flow (DCF) Method

The DCF method of business valuation is similar to the earnings multiplier. This method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The main difference between the discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value.

5. Book Value

This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets.

6. Liquidation Value

Liquidation value is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today.

This is by no means an exhaustive list of the business valuation methods in use today. Other methods include replacement value, breakup value, asset-based valuation and still many more.

Whats IOT – The internet of things

The Internet of Things (IoT) describes physical objects embedded with sensors and actuators that communicate with computing systems via wired or wireless networks—allowing the physical world to be digitally monitored or even controlled.

Does your house have a smart thermostat? Or do you wear a fitness tracker to help you stay physically active? If you do, you are part of the Internet of Things, or IoT. It’s become embedded in our lives, as well as in the way organizations operate.

IoT uses a variety of technologies to connect the digital and physical worlds. Physical objects are embedded with sensors—which can monitor things like temperature or motion, or really any change in environment—and actuators—which receive signals from sensors and then do something in response to those changes. The sensors and actuators communicate via wired (for example, Ethernet) or wireless (for example, WiFi, cellular) networks with computing systems that can monitor or manage the health and actions of connected objects and machines. 

The physical objects being monitored don’t have to be manufactured—they can include objects in nature, as well as people and animals. While some organizations might view IoT more expansively, our definition excludes systems in which all the embedded sensors are used just to receive intentional human input, such as smartphone apps, which receive data input primarily through a touchscreen, or other networked computer software, in which the sensors consist of a standard keyboard and mouse.

The constant connectivity that IoT enables, combined with data and analytics, provides new opportunities for companies to innovate products and services, as well as to increase the efficiency of operations. Indeed, IoT has emerged as one of the most significant trends in the digital transformation of business and the economy since the 2010s.

Ten rules of value-creating growth

Ten rules of value-creating growth

To understand how organizations can try to overcome these obstacles, we studied the growth patterns of the sample companies through various lenses. Our findings suggest ten imperatives that should guide organizations seeking to outgrow and outearn their peers.

  1. Put competitive advantage first. Start with a winning, scalable formula.
  2. Make the trend your friend. Prioritize profitable, fast-growing markets.
  3. Don’t be a laggard. It’s not enough to go with the flow—you need to outgrow your peers.
  4. Turbocharge your core. Focus on growth in your core industry—you can’t win without it.
  5. Look beyond the core. Nurture growth in adjacent business areas.
  6. Grow where you know. Focus on growing where you have an ownership advantage.
  7. Be a local hero. Commit to winning on the home front.
  8. Go global if you can beat local. Expand internationally if you have a transferable advantage.
  9. Acquire programmatically. Combine healthy organic growth with serial acquisitions.
  10. It’s OK to shrink to grow. Ruthlessly prune your portfolio if you need to.

Getting markdowns right: Four questions to answer

Getting markdowns right: Four questions to answer

A retailer’s markdown strategy should provide data-driven answers to the following four questions:

1. Selecting the right items: What items should be put on clearance, given their performance during the season?

To identify which items to mark down, a retailer should compare each item’s performance in the current season against the sales plan for that particular item. A simple data-visualization approach can help merchants easily identify which items in the portfolio are overperformers and which are underperformers.

2. In the right places: Where should items be put on clearance, given performance across store clusters or channels?

Ideally, a retailer would conduct item-level analysis for each store or store cluster rather than applying the same markdown strategy across all stores and channels. Store clusters could be derived based on, for example, climate zones, locations (rural versus urban), assortment tiers, or store sizes. An apparel retailer might find that certain swimwear SKUs sell well throughout the year in some of its urban stores in the Northeast United States. It could then apply markdowns more selectively, instead of simply marking down all swimwear in all Northeast US stores during the colder months.

Similarly, some markets might require more frequent price changes than other markets. By differentiating its markdown strategy based on consumer preferences and shopping behaviors in each location, a retailer can ensure that it is investing its markdown dollars where they’ll make the biggest difference.

The same logic applies to channels. Digital channels can more easily accommodate differentiated markdown approaches since pricing changes are easier and faster to execute digitally—and can be done without adversely affecting customer experience.

3. At the right times: When should items be marked down?

At best-in-class retailers, merchants and planners run scenario analyses to determine the timing and frequency of markdowns. Typically, they apply markdowns in phases, starting with a smaller discount—and then, depending on how the discounted items perform, further lowering prices a few weeks later. A typical mistake that retailers make is failing to revisit markdown decisions: an item could remain on the shelf for weeks if the initial markdown wasn’t deep enough.

4. At the right price: How deep should markdowns be to achieve margin and sell-through goals?

For an item identified as a markdown candidate, a retailer can derive the right clearance price—one that optimizes for both gross margin and sell-through—using consumer-centric analytical models and coherent business rules. Discount depth can vary across categories or SKUs. There are, of course, trade-offs between simplicity and precision: applying the same discount rate to all products within a category requires little effort from store associates, whereas applying differentiated discounting depths is a much more time-intensive exercise for store staff.

To optimize markdown pricing, top-performing retailers use industry-leading analytics and modeled elasticities that are grounded in full-year consumer pricing behavior, with specific adjustments for markdown.