How to Do a Business Valuation: 5 Methods With Examples

Let’s avoid another WeWork fiasco, shall we?

The popular coworking company cut its once $47 billion valuation to just $10 billion, removed its CEO, and delayed its IPO indefinitely. Yikes. 

What happened? Essentially, the venture capitalists were shooting for the moon. No,  really, one of the initial WeWork ideas was to put office space on Mars. 

While there are several ways to do a business valuation, spreadsheet software can organize, catalog, and maintain data in an easy-to-understand manner for real-time collaboration and analysis.  

Whether you need advanced financial modeling, real-time collaboration, or automation, the best spreadsheet tool can make your valuation process smoother and more accurate.

Let’s discuss how to do a business valuation and the different methods you can use.

Why do you need a business valuation?

The preferred business valuation model will differ depending on factors such as the size of the business or industry. The process can be complex and involve several calculations. But why do we need a business valuation in the first place?

• Tax purposes 
• When you wish to sell your business
• If you choose to add shareholders
• While looking for business investors or financial advisors
• If you wish to merge or acquire a business
• While establishing partnership and ownership

Business valuation methods

In this section, we answer your question: How do I value my business? You can use five methods: the asset approach, income approach, market approach, return on investment (ROI) approach, and discounted cash flow approach. 

1. Asset approach

The asset approach essentially totals up all of the investments in the business. With this business valuation, you see a business as consisting of only assets and liabilities. 

Basically, the contents of your balance sheet create the foundation for the value of your business. 

• Going-concern asset-based approach: Takes the business’s net balance sheet sum of assets and subtracts the sum of its liabilities.
• Liquidation asset-based approach: Evaluates the net amount that would be received if all assets were sold and liabilities were paid off.

The asset-based valuation method works well for corporations since the assets are owned by the company itself and are also included in sales. This approach can be difficult for sole proprietors as it can be quite difficult to separate personal and business assets. Let’s take an example in which a sole proprietor wants to sell their company; a prospective buyer would have to sort through assets to determine which assets belong to the owner and which to the business. 

Both of these methods require a strong understanding of a business’s current standing and balance sheet. In short, this business valuation method is like asking, “What will it cost to build an identical business?”

2. Market approach

When valuing a business with the market approach, you look to the external marketplace. In other words, “What are other businesses that are competitive or similar to mine worth?” 

Similar to buying a house, you have to look at comps and evaluate the worth from there. This valuation method is not always an option if you’re creating a category, as it only works if there’s enough to compare it against.

The ‘going rate’ is known as fair market value – a value exchanged between a buyer and a seller that is agreeable and mutually beneficial to both parties. 

For example, your business assets are worth $4 million. If a similar company is being sold for $3.5 million, you may lose money on the sale. The market approach might be popular, but evaluating whether it’s the right approach for your business is key to determining the right business valuation. 

3. Income approach

The income approach, also known as the earning value approach, relies heavily on the probability of the business being profitable in the future. 

What’s most important when valuing a business? Return on investment (ROI)! This business valuation method puts ROI front and center, basing the numbers on what someone can expect to make on their investment.

• Capitalizing past earnings: Projects the company’s potential profits based on its past earnings, adjusting them for unusual or one-off expenses or revenue, and then multiplying by a capitalization factor.
• Discounted future earnings: Determines the value by averaging the trend of predicted future earnings and then dividing that by the capitalization factor.

The capitalization factor largely depends on the earnings history of the business. It can typically range anywhere from 12% for an established business to 50% for an unproven business in a volatile market. 

If your business shows steady profit growth year over year, the capitalization method based on past earnings is the way to go. If you are a rapidly changing startup, the best bet for your business valuation would be discounting future earnings. 

To calculate the business value with the help of capitalizing past earning method under the income method, we can use the following formula.

Business Value = Annual Future Earnings/Required Rate of Return

For example, if a real-estate company named ABC has a forecasted earning of $19 million and the required rate of return is 12%, the business valuation would be $19 million/12% = $158.33 million.

4. Return on Investment (ROI) approach

The return on investment (ROI) approach allows you to value the business based on the profitability and the ROI that an investor can potentially receive if they buy into the business.

Let’s understand how to value a business based on revenue with the help of an example. You pitch the business to investors and ask for $250,000 in exchange for 25% of your business. Divide the amount by the percentage offered, $250,000/0.25 = 1 million. 

This method makes sense from investors' perspective since they would know what to expect as their ROI. However, the valuation ultimately depends on the market. An investor may want to know how long it takes to recover the original investment, the expected net income, etc. 

5. Discounted cash flow (DCF) approach

The discounted cash flow approach (DCF) approach values a business based on the projected cash flow adjusted to its present value. It can be particularly useful when profits are not projected to remain constant in the future. This method requires careful calculations. 

The formula used to calculate DCF is as follows: 

DCF = Terminal Cash Flow / (1 + Cost of Capital) 

Analyzing the DCF shows the company's ability to generate liquid assets. However, one of the challenges faced would be the accuracy of the terminal value, which may vary based on the assumptions about discount rates or growth of the company.  Let's understand this better with the help of an example.

There is an investment opportunity that may produce $100 per year at a discount rate of 10%. To calculate the present value and the stream of future cash flows, we must reduce the present value of each cash flow by 10%. The cash flow for the first year is $90.91, the second year is $82.64, and the third year is $75.13. Adding these cash flows gives us the DCF of the investment as $248.68. 

Which business valuation method is right for you?

Choosing the right business valuation method is crucial. While you might want to try them all and compare your findings, most businesses use a combination of methods to find a true value. There are a few things to keep in mind before you start crunching some numbers. 

Every business is different, and what works for one, even a similar one, won’t necessarily be the right business valuation method for yours. That means that what you’ve used to evaluate past businesses might not be the right one you should use for this new venture. 

Also, you might not be the best person to evaluate your own business. You’re too close to it and bound to inflate a few numbers here and there based on hopes and wishes, thus throwing the whole projection off. A business valuation needs to be objective to be right. 

Determine your business's worth 

No matter the size of your business, a business valuation must be done at some point – maybe multiple times and in multiple ways. This is an extremely flexible process, which makes it even more difficult. However, choosing the right business valuation method will help determine how much the business is worth and help make the right strategic decisions to aid growth. 

Investing and managing business assets can be scary. Learn more about asset management and why it's important for your business before you make your next big move!

This article was originally published in 2023. It has been updated with new information.