Business valuation formula represents a computational procedure used to determine the value of a business.
What It Means
You can measure the value of any business three ways, formally known as the business valuation approaches:
- Market approach
- Income approach
- Asset approach
Each approach offers you a different view of what a business is worth. To actually calculate the business value, you can select a number of business valuation methods.
Business valuation formulas are the computational building blocks behind each valuation method.
Market business valuation formulas
The methods under the market approach typically use a number of valuation multiples. These multiples are ratios that link the business market value to some measure of the company’s economic performance. As a result, you can estimate business value by multiplying, say, the business’ EBITDA by the appropriate valuation multiple. Moreover, you may need to adjust this multiplication result by adding the value of some business assets such as inventory.
Importantly, valuation multiple formulas derived from similar business sales offer a quick and compelling way to calculate your business value. To do this you need the actual selling prices of businesses that are similar, but not identical, to your business.
To get an accurate estimate of the business value, you may use a number of such business valuation formula multiples. Applying each multiple gives you a way to determine the business’ value in relation to its revenues, profits, assets and so on.
Mistakes to avoid with valuation multiples
The relevance and accuracy of such business valuation formulas depend upon the proper choice of business sale comparables.
For a small private company, the sales of similar small private businesses may offer a good comparison. So you could use such data as the basis to develop the valuation multiples.
However, you should be very careful with valuation multiples derived from public company sales. They cannot be used without the important adjustments for small business lack of marketability, size, and whether the business ownership interest sold is controlling or not.
It is essential to apply your valuation multiples to the correct measure of business financial performance. For example, if your valuation multiple is 3 times the business discretionary cash flow, do not use it to multiply your business gross revenues or net income!
To see how valuation multiples are used for business selling price estimation, please take a look at this example.
Income business valuation formulas
The income valuation methods offer you a way to calculate business value based on the company’s earnings prospects and risk. All income business valuation methods fall into two main types:
- Capitalization methods
- Discounting methods
The choice of the business valuation formulas also differs, depending on the valuation method you choose. For example, the capitalization formulas involve the division of business earnings by the so-called capitalization rate. On the other hand, you can also do this by using an earnings multiplier, such as with the Multiple of Discretionary Earnings business valuation method.
In contrast, the discounting methods require that you specify a projected stream of business income first. The value of the business in present day dollars is then computed using the discounting valuation formula. Importantly, the discounting formula requires an income stream forecast. So this makes the calculation more complex. The best-known example of this is the Discounted Cash Flow method.
Asset business valuation formulas
Asset valuation methods let you determine the company’s worth based on the values of its assets and liabilities. The main asset valuation methods are:
- Capitalized Excess Earnings Method
- Asset Accumulation Method
The Capitalized Excess Earnings method uses a number of business valuation formulas to calculate the total business value as a sum of the company’s tangible assets and business goodwill.
The valuation formulas for the asset accumulation method are essentially a set of adjustments that you make to the book values of the business assets and liabilities.
You start with the company’s accounting balance sheet and review the assets and liabilities. Next, you adjust the numbers up or down. You do so to figure out the true market values of the company’s assets and liabilities. Your analysis may include important off balance sheet items such as internally developed intangible assets and contingent business liabilities.