HOW BUSINESS VALUATIONS ARE CALCULATED
Business valuation is the process of determining the economic value of a company or a business entity. Business valuations are commonly performed for a variety of reasons, such as mergers and acquisitions, estate planning, tax purposes, and financial reporting.
There are several approaches used to calculate business valuations, including the market approach, the income approach, and the asset approach. Each approach has its own strengths and weaknesses, and the best approach depends on the specific circumstances of the business being valued.
Market Approach The market approach to business valuation is based on the principle of supply and demand. It involves comparing the business being valued to similar businesses that have been sold recently. This approach assumes that the market price of the business is determined by the prices paid for similar businesses.
To use the market approach, the valuation expert first identifies a set of comparable businesses that have been sold recently. The expert then calculates the multiples of earnings or revenue that were used to determine the sale price of each comparable business. These multiples are then applied to the financial metrics of the business being valued to arrive at an estimated value.
Income Approach The income approach to business valuation is based on the principle that the value of a business is equal to the present value of its future cash flows. This approach assumes that the value of a business is determined by the income it generates.
To use the income approach, the valuation expert first forecasts the future cash flows of the business being valued. The expert then applies a discount rate to the cash flows to reflect the risk associated with the business. The present value of the discounted cash flows is then calculated to arrive at an estimated value.
Asset Approach The asset approach to business valuation is based on the principle that the value of a business is equal to the sum of its parts. This approach assumes that the value of a business is determined by the value of its assets.
To use the asset approach, the valuation expert first identifies and values the assets of the business being valued. This includes both tangible assets, such as property, plant, and equipment, and intangible assets, such as patents and trademarks. The value of the assets is then added together to arrive at an estimated value.
Conclusion Business valuations are complex and require a thorough understanding of the business being valued and the market in which it operates. The three approaches to business valuation – market, income, and asset – provide different perspectives on the value of a business and can be used in combination to arrive at a comprehensive valuation. It is important to work with an experienced valuation expert to ensure that the valuation is accurate and reflects the specific circumstances of the business being valued.
