Business Valuation - The Basics

A business valuation requires a working knowledge of a variety of factors, and professional

judgment and experience. This includes recognizing the purpose of the valuation, the value
drivers impacting the subject company, and an understanding of industry, competitive and
economic factors, as well as the selection and application of the appropriate valuation
approach(es) and method(s). Some of the more important considerations are discussed below.

Why Would You Need a Business Valuation?

Due to the complexity of the business valuation process, these calculations are probably not
something you’ll be doing every day—so, when would you need a business valuation?

Overall, there are a handful of common reasons why business owners need to evaluate the worth
of their company:

 When looking to sell your business

 When looking to merge or acquire another company
 When looking for business financing or investors
 When establishing partner ownership percentages
 When adding shareholders
 For divorce proceedings
 For certain tax purposes

What is the purpose of the valuation?

Identifying the purpose of the business valuation is a critical first step in the process as it dictates
the “basis of value” or “standard of value” to be applied, which, in turn, impacts the selection of
approaches, inputs and assumptions considered in the valuation. The purpose of a valuation
could be for acquisition or sale, litigation, taxation, insolvency, or financial reporting, to name
just a few. Once the purpose is identified, the appropriate standard of value can be applied. For
example, a tax valuation for U.S. tax reporting generally requires fair market value, defined by
U.S. tax regulations and further interpreted by case law while financial reporting requires fair
value as defined by U.S. and IFRS accounting standards as a basis of value. While all valuations,
regardless of purpose, share certain common attributes, there are differences that need to be
reflected in the analysis pursuant to the basis of value. These differences can have a significant
impact on the outcome of the business valuation.
What basis of value should apply?
The basis of value (or simply put, value to whom?) describes the type of value being measured
and considers the perspectives of the parties to the assumed transaction. For example, the basis
of value may be defined as the value between a willing buyer and a willing seller or as the
investment value to the current owner. Thus, the basis of value may have a significant impact on
the selection of valuation approach(es), method(s), inputs and assumptions. It is often specified
by a statute, regulation, standard, contract or other document, pursuant to which the valuation is
performed. Therefore, the purpose of the valuation and the applicable basis of value are linked.

What premise of value should be used?

The valuation approach(es), inputs and assumptions applied are highly dependent on the selected
premise of value. The premise of value is driven by the purpose of the valuation and basis of
value used, and generally falls into the following categories:

 A going concern premise is the most common premise of value; it

presumes the continued use of the assets, and that the company would
continue to operate as a business.

 An orderly or forced liquidation premise incorporates an in-exchange

assumption (i.e., the assets are operated or sold individually or as a
group, not as part of the existing business).

What is the subject of the valuation?

The subject of the valuation is of vital importance to the valuation process, the selection of inputs
and approach(es) and method(s). Valuing the invested capital or common equity of a business,
options, hybrid securities, or some other form of financial interests in a business each require the
application of specific valuation methods (a.k.a. techniques, all falling under three main
valuation approaches), that are tailored to reflect their specific attributes and terms. Additional
complexities arise when one valuation may be required as an input to perform another. For
instance, a business valuation may serve as an input or a distinct step in the valuation of stock
options, preferred stock, or debt. A business interest (ownership interest in a business), on the
other hand, may be characterized by various rights and preferences such as voting rights,
liquidation preferences, redemption provisions, and restrictions on transfer, each having an
impact on the value measurement.

How has the business performed historically?

Regardless of the business valuation approach applied, an understanding of the company’s

history and evolution, management and ownership structure, and financial measures of historical
performance, is imperative. Financial ratio, margin and growth analysis - the nature of which
may vary across industry sectors - provide requisite insight into historical performance. Industry
benchmarks offer a frame of reference to evaluate the subject company’s performance relative to
its peer group. For example:

 The ratio of enterprise value to the historic amount of invested capital

provides an indication of the market’s perception of the ability of the
guideline companies to create value. 

 Measures such as return on invested capital (ROIC) and an evaluation

of competitive advantages, including unique or innovative products, offer
insight into how value is being created in the industry, and present
benchmarks to assess the performance of the subject company.

Analyses of historical performance also require careful consideration of additional items and
factors, such as non-operating assets and non-recurring events. Businesses are generally valued
by first estimating the value of the operations and then adding any non-operating assets.
Therefore, isolating and valuing the non-operating assets is important, especially when they are
material. Non-recurring events should be removed from historical performance in order to get a
more representative measure of the indicated future value of operations.

What is the future outlook for the business?

While the historical analyses described above are a key consideration, so are a company’s future
prospects. After all, a business derives its value primarily through its ability to create value in the
future. In simple terms, value is created when management invests available capital in a manner
that provides returns in excess of the cost of that capital. When investment returns equal the cost
of capital, no value is created, and when returns fall below the cost of capital, value is eroded.

An assessment of a company’s future outlook comprises understanding the company’s continued

strategy in managing its current operations and the expected performance of its future
investments. This may include the evaluation of detailed forecasts, revenue, volume and market
share data, operating expenses, taxes, capital requirements, cost of capital, etc., and various
scenarios thereof. Industry and guideline company analyses also provide insight into a
company’s expected performance and future value creation, on a more macro level.

Understanding management’s expectations for the ongoing value creation process; whether it
would be built upon continuing successes of the past or through new strategic directions; and
whether it is to be generated organically or through acquisitions, is critical in evaluating the
future outlook of the business. Business expectations that deviate significantly from prior
performance should trigger an incremental level of scrutiny in the analysis due to the lack of
historical reference points.
Which valuation approaches should be utilized?

With all this foundational information and the assumptions in place, the analysis turns to the
selection of valuation approach(es). The income, market and cost approaches are the three
generally accepted valuation approaches. The selection of valuation approach(es) depends on the
facts and circumstances of the subject company. A brief summary of each approach follows.
Methods of Valuation
There are numerous ways a company can be valued. You'll learn about several of these methods
below.

1. Market Capitalization
Market capitalization is the simplest method of business valuation. It is calculated by multiplying
the company’s share price by its total number of shares outstanding. For example, as of January
3, 2018, Microsoft Inc. traded at $86.35. With a total number of shares outstanding of 7.715
billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.

2. Times Revenue Method

Under the times revenue business valuation method, a stream of revenues generated over a
certain period of time is applied to a multiplier which depends on the industry and economic
environment. For example, a tech company may be valued at 3x revenue, while a service firm
may be valued at 0.5x revenue.

3. Earnings Multiplier
Instead of the times revenue method, the earnings multiplier may be used to get a more accurate
picture of the real value of a company, since a company’s profits are a more reliable indicator of
its financial success than sales revenue is. The earnings multiplier adjusts future profits against
cash flow that could be invested at the current interest rate over the same period of time. In other
words, it adjusts the current P/E ratio to account for current interest rates.

4. Discounted Cash Flow (DCF) Method

This method of business valuation is similar to the earnings multiplier. This method is based on
projections of future cash flows, which are adjusted to get the current market value of the
company. The main difference between the discounted cash flow method and the profit
multiplier method is that it takes inflation into consideration to calculate the present value.

5. Book Value
This is the value of shareholders’ equity of a business as shown on the balance sheet statement.
The book value is derived by subtracting the total liabilities of a company from its total assets.

6. Liquidation Value
This is the net cash that a business will receive if its assets were liquidated and liabilities were
paid off today.
How do you arrive at a conclusion of value?
The resulting value indications from the approaches and methods applied would be evaluated
and weighted, on a qualitative basis, as appropriate. In many cases, a greater weight may be
ascribed to a particular approach. For example, when the guideline companies are not truly
comparable to the subject company, a greater weight may likely be placed on the indication of
the income approach. However, this should not preclude consideration of the market approach
altogether, as it can still serve as a reasonableness check of the valuation conclusion.

If the valuation is for a business interest (for example, a minority, or non-controlling ownership
interest in the business), additional adjustments for lack of control and/or lack of liquidity or
restrictions on marketability may be required, depending on the facts and circumstances, and the
specific rights of the holders of the class of equity interest.

As you can see, the valuation of a business or a business interest is often a complex process
involving a number of considerations, ranging from defining the purpose of the valuation, the
basis and premise of value used, the historical performance and future outlook for the subject of
the valuation. While standard valuation approaches exist, the challenges lie in selecting the
appropriate approach(es), developing the inputs, appropriately weighting the value conclusions,
and making any adjustments, using judgement. While valuation appears to be entirely
quantitative, the reality is that significant consideration is also given to all relevant qualitative
factors, and that professional judgment is critical.