Business Valuation - In Theory and Practice

Summary of Business Valuation Methods

Knowing what business valuation methods are available for a business will give you an advantage when you are selling or preparing to sell.

Steps Before Selling

The first step in valuation is to determine if the business is a going concern, meaning if the business has sustainable cash flows that can be transferred to a third party buyer. If not, then the liquidation of the assets en bloc or piecemeal may result in a higher value than selling the business as an operating entity.

The liquidation method is the least attractive exit option for business owner. Forced liquidation might occur if the business is in default of any its financial obligations. In this case, there is very little time, so you have to assume an immediate shutdown of operations and sale of the assets. A more likely situation may be that the business is not in duress and simply fetches a better price via liquidation rather than a future income or free cash flow based method, and then we are dealing with an orderly liquidation. In this case, the business has time to maximize the proceeds for its assets via liquidation. More importantly, the business can still generate income while its orderly liquidation is occurring, and this income also needs to be taken into consideration when estimating value. An orderly liquidation is definitely the more advantageous business valuation method if the business is not a going concern.

If the business is a going concern, then a future income or free cash flow based method is more appropriate as it will yield a higher value. We cannot overemphasize the importance of free cash flow enough. It is the largest contributor of determining value in any business.

Income Based Methods

There are two income based methods that you need to know about. They are:
  1. The capitalization of after tax free cash flows - This approach is good for mature businesses where historical cash flows are considered to be a good approximation of future cash flows. Normalizations are made for unusual or non-recurring income or expenses. These cash flows are tax-effected, and then they are capitalized using a capitalization rate. Adjustments should be considered if sustaining capital expenditures are not consistent with the depreciation expense on the income statement.
  2. Discounted cash flow - This is the most favored business valuation method. Here we compute the future free cash flow on a year by year basis and then discount each year to its present value. This is the right method to use if the business is ongoing but may have a finite life like say a franchise. It is also the right method for businesses that are growing and have high demands for working capital or growth capital expenditures since both these factors impact each year’s free cash flow.
We did not include the capitalization of EBITDA or capitalization of EBIT as separate methods because they are simply variations or types of earnings capitalizations. They provide a simplified way of determining a reasonable value range, and can serve as good metrics of value.

General Methods

Keep in mind that these are general business valuation methods that each have different nuances and, more importantly, are situation specific. You will want to do as much due diligence on the business to understand it as best as possible.

Remember that the valuation of a business is still more of an art than a science, but there is a definite methodology to follow depending on the circumstances. Applied knowledge and preparation is a powerful edge to have.

Share this:
Written by Divestopedia Team
Profile Picture of Divestopedia Team
Divestopedia is a resource for entrepreneurs who want to sell their business for the best price and terms. Whether you are thinking of selling, have started a sales process, or are post-deal, we aim to arm you with the knowledge required to maximize value and limit your downside risk. Full Bio