Let’s avoid another WeWork fiasco, shall we?
The popular coworking company cuts its once $47 billion valuation to just $10 billion, removed its CEO, and delayed its IPO indefinitely. Big 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.
So, how do you value a business?
What is a business valuation?
A business valuation is the result of the process and procedures used in estimating what a business is worth or its economic value. A business’s value isn’t always straightforward and in order to get the right business valuation, you have to conduct a considerable amount of research on the company itself and its current market.
Let’s discuss how business valuations work and the different methods you can use.
3 business valuation methods
There are three main ways to value your business: asset approach, income approach, and market approach. Of course, there are a few variations within each of these business valuation methods.
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.
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?”
TIP: Get your balance sheet in order with this free template!
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 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.
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! This business valuation method puts ROI front and center, basing the numbers off of what someone can expect to make on their investment.
- Capitalizing past earning: 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 earning: 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, but can typically range anywhere from 12% for an established business to 50% for an unproven business in a volatile market.
If your business is showing 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.
Which business valuation method is right for me?
Choosing the right business valuation method is crucial. While you might want to try them all and compare your findings, the majority of 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.
The price is right
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.
Investing can be scary… fun. Check out these investment statistics before you make your next big move!