Many people ask about a business valuation formula that is universally applicable and can be used to quickly give them a reliable value for their business at any given time. However, no single formula for valuing a business exists; rather there are a set of methods that use different formulas that can be used to value a business. Normally, the choice of formula depends on the nature of the business being valued, its growth stage and the availability of data.
There are three main valuation approaches: asset-based valuation, income-based valuation and market-based valuation approach. Below we are describing the most widely used formulas under each valuation approach.
- Asset-Based Valuation Approach
- Market Value of Assets less Book Value of Liabilities – this formula calls for adjusting the book value of assets, which under US GAAP is historical cost less accumulated depreciation to net realizable market value or for how much can the assets of the business be sold under normal market conditions. After that liabilities are subtracted to arrive at a value for the equity of the business.
- Liquidation Value of Assets less Book Value of Liabilities – this formula is used for a company that can no longer afford to continue operating. In this case the company’s assets are adjusted from book value to their net realizable value in liquidation.
- Income-Based Valuation Approach
- Capitalized-Earnings is EBITDA divided by capitalization rate equals business value OR EBIT divided by capitalization rate equals business value. In the case of a small business the appropriate business valuation formula is discretionary cash flow divided by capitalization rate equals business value. EBITDA stands for earnings before interest, taxes and depreciation and amortization while EBIT stands for earnings before interest and taxes. Discretionary cash flow is free cash flow to equity adjusted for any excess salary and perks for the owner.
- Present Value of Discounted Future Cash Flows – this formula requires that first future earnings be projected. Typically, a company projects its cash flows for the next five years and then assumes a terminal growth rate in perpetuity. Then, the appropriate discount rate is determined and applied to each projected cash flow. For the final year, the terminal value is calculated using the earnings/dividend discount model.
- Market-Based Approach
- Market-Multiples – one way to value a company is to take the average ratios from publicly-traded comparable companies. The most common is the price/earnings ratio (P/E ratio) which is calculated using the price per share divided by the earnings per share. Then, we use the earnings of the valued company and multiply it by the average P/E of the peer group to estimate the value of the company’s equity. There are other ratios that use different metrics but work the same as the P/E ratio. Most widely used are EV/EBITDA and Sales/EBITDA. Enterprise value is calculated as market value of equity + market value of debt- cash & equivalents. These two formulas are useful to value businesses that have a different capital structure then their peers, either too much debt or no debt at all.
The application of these formulas requires a great deal of professional judgment. We recommend you retain a certified valuation professional to obtain a realistic estimate of the value of your business. Contact us to help you with your business valuation needs or schedule a consultation with our business lawyers in Miami, Florida USA.
Malescu Law P.A. – Business Lawyers