Selling and buying businesses involves many, many complex questions. One of the first and most important questions is “what is a given business worth, aka what is its valuation?” This question is so tricky because there are different methods available for calculating a business valuation and because each calculation will produce a different result, the valuation of any business will typically be represented by a numeric range. One thing that is true throughout is that people looking to sell or buy businesses should get second (or third or more) opinions, typically from an appraiser, to make sure the math adds up. Even those who buy and sell businesses frequently do this because of how important it is; and because these processes typically involve some very big numbers. Here is what else you should know about business valuations.
An asset-based method of calculating a business valuation focuses on the businesses assets and liabilities. The difference from the 2 (assets minus liabilities) is the overall valuation but there are many other calculations, IRS rules, and factors that go into generating those two numbers for that equation. And even before doing any math, those involved in the valuation process typically pour through large quantities of statistics, receipts, and other records. Business owners typically do not sell businesses for the less than the valuation (also known as a book value) derived from this method, especially businesses that have a lot of growth potential.
The market-based method of calculating a business valuation compares a business that is potentially being bought/sold with a similar one that already has been. The key to this method is finding another company that is truly similar because the more similar it is then the more accurate the valuation will be, even if the end valuation total is very different. The more recent the other company sold, the more accurate the valuation will be too because of the impact inflation and shifts in the market have over the years or decades.
The income-based method of calculating a business valuation looks at a business’s financial books to show it is low in risk and high in potential. Even if a business has taken out some big loans, the ability to pay down loans, especially quickly, reflects good financial health and low risk. Past profits and current cash flow are the major factors in determining the valuation of the business in terms of future net profit.