Business valuation is a process for determining the economic value of a business. It’s a crucial part of the due diligence process, playing a role in scenarios such as mergers and acquisitions (M&A), financing, investments, financial reporting, strategic planning, legal matters, and more. 

Business valuation calculations provide an objective metric for assessing the worth of a business to inform decision-making. There are several methods you can use to determine the value of a business, as well as numerous factors that can impact business valuation. In this guide, we’ll explain business valuation in-depth, the various valuation methods, and some common challenges you might encounter when determining business valuation. 

In this article: 

• When are business valuations used?    
• Standards of value 
• Factors that impact business valuation
• Business valuation methods
• Challenges in business valuation
• Frequently asked questions
• Final thoughts

When are business valuations used?

Business valuations are used in a variety of situations. Here’s a look at some of the most common use cases for business valuations and the role they play in these processes. 

Mergers and acquisitions

Business valuation is crucial for buyers and sellers in M&A transactions. They’re used to establish an appropriate purchase price for the target company based on its financial performance and market conditions. 

Business valuation can provide a foundation for M&A negotiations. It helps both sides of the transaction understand the company’s financial health, profitability, and potential for future growth. Business valuation can be critical for ensuring that both parties agree on a fair price. 

Investment and fundraising

An equity valuation determines the worth of a business before making an investment. When startups or early-stage companies seek funding from investors (venture capitalists or private equity), business valuations help determine the amount of equity an investor should receive in exchange for capital. 

Accurate business valuations help to establish clear expectations for business owners and investors in terms of the ownership structure and potential returns. It also helps investors assess the potential return on investment in relation to the associated risks. 

Exit strategy and succession 

For business owners planning to exit or transfer business ownership to family members or other stakeholders, a valuation helps ensure the transition is financially sound and fair. It gives business owners an understanding of what their business is worth, which helps them prepare for a successful sale (by starting from a reasonable asking price, for example). 

In succession planning, a business valuation ensures that the value is accurately assessed for transferring ownership within families. It also plays a role in estate planning, estimating the company’s worth to help with tax planning and inheritance decisions. 

Financing and collateral valuation

When a business seeks loans or lines of credit, lenders often require a business valuation to evaluate the business’s ability to repay the debt. It also helps to determine the appropriate amount of collateral to adequately cover the lender’s risk. 

Employee stock ownership plans (ESOPs)

Valuations are often used in companies with employee stock ownership plans (ESOPs) to determine the price at which employees can purchase or sell shares in the business. An accurate business valuation ensures fairness and transparency in ESOP transactions. 

Strategic planning

Business valuations are often part of an internal review process to evaluate the company’s performance, future direction, and growth opportunities. Understanding the business’s value helps management set realistic goals, make strategic decisions, and evaluate the effectiveness of past strategies. 

Business valuation also helps to determine where a company stands within its industry, and it can aid in planning for expansion, acquisitions, or capital investments based on the current valuation. 

Financial reporting 

For publicly traded companies and businesses that are subject to regulatory oversight (regional or industry-specific), business valuations may be a requirement for financial reporting purposes. For example, companies may need to comply with accounting standards that require fair value reporting for certain assets and liabilities. Valuations are also used to determine if a business’s value has declined, which may affect asset values on the balance sheet. 

Standards of value 

There are two standards of value when it comes to business valuations: fair market value (FMV) and strategic value. Fair market value refers to the price at which a business would change hands — in the current market conditions — between a willing buyer and a willing seller when both have complete knowledge and understanding of the relevant facts and are not under any compulsion to buy or sell. It’s often used in real estate transactions, tax assessments, and financial reporting. 

Strategic value refers to the additional worth of an asset or investment to a specific buyer or entity based on its strategic goals or market positioning. Also known as investment value, it’s higher than the fair market value because it takes into account the potential benefits to the buyer, such as synergies, competitive advantages, increased profits, reduced costs, or market expansion. Strategic value is often used in mergers and acquisitions, strategic partnerships, and resource allocation. 

Understanding the difference between fair market value and strategic value can significantly impact decision-making. Here are a few examples: 

• In mergers and acquisitions, understanding both values can help a business determine how much to offer for a potential acquisition. The FMV provides a baseline price, but strategic value might suggest that a buyer could justify a higher purchase price based on expected synergies. 
• Investors often use FMV to determine whether an investment is fairly priced, but strategic value can also help to guide investment decisions by evaluating the potential long-term returns an asset could deliver based on the investor’s specific strategy. 
• When considering asset divestitures, companies must consider both fair market value and strategic value. Selling an asset at FMV may not reflect its true worth to the current owner if it holds significant strategic advantages. 

Factors that impact business valuation

Both internal and external factors can impact the value of a business. Here’s a look at some of the biggest factors impacting valuation. 

• Financial performance: Consistent revenue streams and healthy profit margins enhance a company’s value. Positive cash flow can also indicate a business’s ability to sustain its operations and potential for growth. 
• Market conditions: The overall health of the industry and macroeconomic factors can affect business valuation. The competitive landscape and market share also impact a company’s value. 
• Business model and strategy: A scalable business model can have a positive impact on business valuation, and strong brand equity can significantly influence a company’s market value. 
• Management and operations: Experienced and visionary management is often viewed as a strong asset, while streamlined operations can lead to better profitability and valuation.  
• Business valuation methods used: As we’ll discuss later in this guide, some business valuation methods are more suitable for certain situations than others. Plus, some valuation methods rely heavily on the values chosen as multipliers or discount rates, so even a slight deviation in these figures can have a significant impact on the resulting valuation. 

Business valuation methods

When it comes to the actual methods used for business valuation, there are many. Typically, at least two methods are used when valuing a business. Different evaluators, businesses, and industries may have different methods and approaches they prefer to use for business valuations. Also, factors like the type of business, availability of certain data, and the reason for the business valuation can impact whether certain methods are used.  

Discounted cash flow analysis (DCF)

The discounted cash flow analysis method uses future cash flows, adjusted for inflation, to estimate a business’s value. It’s typically used when a business has predictable future cash flows and is expected to continue operating indefinitely. It involves forecasting future cash flows and discounting them to their present value using a discounted rate to account for the risks involved. 

Pros: 

• Reflects the company’s future earning potential 
• Suitable for companies with stable and predictable cash flows
• Focuses on future performance rather than historical data

Cons: 

• Requires accurate financial projections, which can be difficult for startups or businesses with fluctuating earnings
• The accuracy of the valuation depends heavily on the discount rate used
• It can be complex and time-consuming to calculate 

Revenue multiple method 

The revenue multiple method estimates a company’s value by applying a multiple to its revenue. It’s often used for companies in industries where profitability can be difficult to measure or less relevant, such as startups or companies in high-growth phases. 

The revenue multiple is typically determined by analyzing comparable companies within the same industry or recent market transactions, reflecting how much investors or buyers are willing to pay for each dollar of revenue.

Pros:

• Simple to calculate, no complex adjustments needed.
• Suited for startups or low-profit companies where revenue signals growth potential.
• Highlights revenue generation ability.

Cons:

• Ignores profitability and operational efficiency.
• Risks overvaluing unprofitable companies.
• Unsuitable for profit-driven businesses as it overlooks costs and earnings.

Capitalization of earnings method 

The capitalization of earnings method is often used to determine a company’s valuation based on its ability to generate future revenue. It’s a simpler version of the discounted cash flow analysis. 

The capitalization of earnings method estimates a company’s value by dividing its expected future earnings by a capitalization rate (also known as the capitalization multiple). In this method, earnings refer to the company’s normalized or adjusted earnings, such as net income, EBIT (earnings before interest and taxes), or EBITDA (earnings before interest, taxes, depreciation, and amortization). 

The capitalization rate is an interest rate or return on investment the investor requires. It reflects the risk of the business and industry, the company’s future growth prospects, and the level of risk associated with the earnings stream. The capitalization rate is calculated as the required rate of return or discount rate minus the growth rate. 

Pros:

• Simple and easy to apply.
• Best for businesses with stable earnings.
• Focuses on earnings, a key concern for investors.

Cons:

• Unsuitable for high-growth or volatile industries.
• May oversimplify risks and market conditions.
• Valuation heavily depends on the chosen capitalization rate.

EBITDA multiple method 

The EBITDA multiple method calculates a company’s value based on its earnings before interest, taxes, depreciation, and amortization (EBITDA). It uses an industry-specific multiple of EBITDA, and it’s often used in mergers and acquisitions to provide a quick, market-based valuation. 

Pros:

• Quick and simple for M&A valuations.
• Based on comparable transactions or market data, ideal for M&A-heavy industries.
• Focuses on operational performance, ignoring capital structure differences.

Cons:

• Can overvalue companies with high debt or depreciation.
• May undervalue high-growth companies.
• Overlooks intangibles like IP and customer relationships.

Market-based approach

The market-based approach compares the business to similar companies in the same industry that were recently sold or are publicly traded. Typically, the valuation uses market multiples like price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, and EBITDA (earnings before interest, taxes, depreciation, and amortization).  

Pros:

• Captures market trends and investor sentiment.
• Offers benchmarks from real transactions.
• Relies on observable data, not projections.

Cons:

• Finding true comparables can be challenging.
• Ignores internal factors affecting value.
• Market volatility can skew valuations.

Asset-based approach

The asset-based valuation approach determines a business’s value by evaluating the company’s assets and liabilities, essentially looking at its net asset value (NAV). It’s suitable for businesses with many assets or for companies that are being liquidated. 

The asset-based approach calculates the net value of a company’s assets (total assets - liabilities). The business’s value is based on the fair market value of its tangible (e.g., equipment, real estate) and intangible assets (e.g., trademarks, patents).  

Pros:

• Easy to calculate.
• Suitable for asset-heavy companies.
• Helpful for distressed or liquidated businesses.

Cons:

• Ignores future earnings.
• Undervalues intangible assets like brand and IP.
• May underprice low-asset, high-earning companies.
• Fails to reflect market conditions.

Rule of thumb method

The rule of thumb valuation method, also called the industry multiples method, is often used for small businesses when more sophisticated valuation techniques aren’t practical. It can also be used to calculate a quick ballpark estimate of a company’s value. 

This method uses an industry-specific multiple, which is typically based on metrics like revenue, gross profits, or the number of customers the business has. 

Pros:

• Fast and simple.
• Ideal for rough estimates.
• Practical for small businesses when other methods are impractical.

Cons:

• Often imprecise and generalized.
• Overlooks financial health and growth prospects.
• Inaccurate for businesses with unique traits.

Cost approach 

The cost approach to business valuation estimates a company’s value based on the cost to recreate or replace its assets. It’s often used for startup companies or in situations involving unique assets. 

Pros:

• Easy to calculate using tangible asset values and replacement costs.
• Provides a baseline for startups without proven income streams.

Cons:

• May not reflect market conditions or goodwill.
• Undervalues established businesses with strong cash flow.

Contingent claim valuation

Contingent claim valuation is also called real options analysis, and it’s often used in situations with significant uncertainty or for businesses with significant future growth potential. This method treats certain business decisions (such as expanding operations or entering new markets) as options with embedded value, evaluating them based on the flexibility they offer. 

Pros:

• Ideal for high-growth, dynamic industries.
• Considers uncertainty and future opportunities.

Cons:

• Complex and challenging to apply accurately.
• Requires advanced modeling and assumptions about growth and risk.
• Unsuitable for businesses lacking clear strategic options.

Excess earnings method

The excess earnings method is typically used for businesses with significant goodwill (such as franchises or businesses with valuable customer relationships) or for valuing intangible assets. It separates the company’s earnings into two categories: normal earnings and excess earnings. The excess earnings are then capitalized to estimate the business’s value. 

Pros:

• Effective for businesses with substantial intangible assets.
• Ideal for valuing professional practices or IP-heavy businesses.

Cons:

• Involves subjective estimates and complexity.
• Less suitable for asset-heavy businesses or those lacking intangibles.

Present value of a growing perpetuity

The present value of a growing perpetuity method is used to estimate the value of a company that’s expected to generate cash flow that grows at a constant rate indefinitely. It’s particularly useful for businesses with stable, predictable cash flows that are expected to grow at a constant rate over time. For example, it’s often used for mature businesses or businesses in industries where growth is expected to be steady, such as utilities or established consumer goods companies. 

Pros:

• Simple and easy to apply.
• Suitable for companies with stable, predictable growth.
• Focuses on expected future cash flows, key for investors.

Cons:

• Overly simplistic with constant growth assumptions.
• Unsuitable for volatile or fast-changing industries.
• Ignores operational factors, competition, regulations, and consumer trends.

Enterprise value (EV) method 

The enterprise value (EV) method calculates the total value of a company, including its equity and debt, while excluding cash and cash equivalents. It’s often used in M&A transactions to determine the overall cost of acquiring a business because it represents the value of the enterprise as a whole rather than just its equity. 

Pros:

• Offers a precise estimate of acquisition cost.
• Ideal for M&A, accounting for equity and debt.
• Highlights operational value over inactive cash reserves.

Cons:

• Ignores future performance.
• Risks inflated valuations if debt or financial distress is overlooked.
• Omits qualitative factors like brand, market position, and intangibles.
• Misleading for cash-rich companies.
• Requires complex calculations and extensive data.

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Challenges in business valuation

As you probably noticed in the previous section, business valuation is an imperfect science. Let’s look at the limitations of business valuation and the most common challenges. 

Lack of accurate data

A lack of accurate, comprehensive data can be a serious challenge when valuing a business. Valuators often rely on financial statements, market data, and industry reports, but these sources may not always provide a complete picture. Inaccurate or outdated information can lead to unreliable valuation. 

To avoid this, valuators must conduct in-depth research to gather the most current and relevant data. It’s also crucial to cross-reference information from various reports and sources to confirm accuracy. 

Subjectivity in valuation methods 

A common theme when we discussed the various business valuation methods earlier in this guide was that valuation methods often rely on qualitative or subjective information. Different methods can produce vastly different results, so choosing the appropriate methods for each situation is vital — and it requires expertise and experience to get it right. 

To overcome the subjectivity in these methods, you can utilize standard methodologies that can reduce inconsistencies across valuations. It’s also important to use at least two valuation methods, which can help to distinguish certain factors that may be having a significant impact on the valuation and whether a calculation should be discarded. 

Economic and market fluctuations

The economic environment can have a significant impact on business valuations. Factors like changing market conditions, interest rates, and economic downturns can significantly alter a company’s value. This volatility makes it challenging to ensure that the valuation reflects current and future market expectations. 

One solution for this concern is to use scenario analysis to assess how various economic conditions could influence the valuation. You should also regularly update valuations to reflect the current market conditions and economic trends. 

Business complexity 

As businesses grow in size and complexity, their operations, financial structures, and market strategies also become increasingly complex. Valuing a multifaceted business with multiple revenue streams, a presence across different geographic regions, or different business units can be quite challenging, which may result in inconsistencies in valuations. 

To deal with this complexity, you can break down the business into smaller units for individual valuation and then aggregate the results. It’s also helpful to use industry benchmarks to provide context and a basis for comparative analysis. 

Lack of comparable businesses in the market

While a lack of similar businesses in the market is a good thing regarding a company’s competitive advantage and market share, it’s not so great for business valuations. This is commonly the case for unique or niche businesses. When valuators can’t find comparable businesses, it eliminates market-based valuation approaches. 

Of course, you can always turn to other valuation methods, but you can also broaden your search to find comparable companies in adjacent industries or those with similar business models. You should also make any necessary adjustments to account for the company being valued and its potential comparables. 

Intangible assets and goodwill 

Valuing intangible assets like brand reputation, intellectual property, and customer relationships can be challenging. Because intangible assets don’t have a physical form, it’s often difficult to quantify their impact on the company’s overall value accurately. 

Using specialized appraisers with experience valuing intangible assets can help to better account for these assets. One thing to keep in mind, though, is that you’ll want to consider the risks associated with these intangible assets and incorporate them into the business valuation. 

Frequently asked questions

What’s the difference between a business valuation and an appraisal? 

A business valuation is a comprehensive analysis used to determine the overall value of a company based on various financial and operational factors. It’s typically used for mergers, acquisitions, or investment decisions. 

An appraisal, on the other hand, is a more specific assessment, often focusing on the value of individual assets, property, or tangible items. Appraisals are commonly used for insurance or tax purposes.

What are the disadvantages of business valuation? 

Business valuations can be subjective and influenced by the methods or assumptions, leading to potential inaccuracies. They may not reflect sudden market changes, and they can be costly and time-consuming to conduct. Business valuations can also vary based on the appraiser's perspective, making it less reliable in certain circumstances.

What are the main factors affecting a company’s valuation? 

Key factors affecting a company’s valuation include its financial performance (e.g., revenue, profitability), market conditions, industry trends, management team, growth potential, and competitive position. Other considerations, such as intellectual property, brand value, and the company’s debt, also play significant roles in determining its value.

What approach is used most often for the valuation of a business? 

The most commonly used approach for business valuation is the income approach, particularly the discounted cash flow (DCF) method. This method calculates the present value of future cash flows that the business is expected to generate. Other approaches include the market approach and asset-based approach, which compare the business to similar companies or assess the value of its assets.

How many times profit is a business worth? 

The valuation multiple used to determine a business’s worth relative to its profit varies depending on the industry, market conditions, and the business’s financial health. A common benchmark is the price-to-earnings (P/E) ratio, but multiples can range widely from 3 to 10 times profit or more, depending on these factors.

How accurate are business valuations? 

Business valuations are generally accurate within a certain range, but they are not exact. They rely on assumptions and forecasts, which can change over time. The accuracy of a valuation depends on the quality of the data, the methodology used, and the expertise of the appraiser.

Final thoughts

Business valuation is an integral component of the due diligence process, but it can be complex and time-consuming. DealRoom Diligence provides a central, unified tool for tracking all documents and data you need for business valuation and other aspects of the due diligence process. It also unifies due diligence requests and communications, providing greater transparency and making the process more efficient. DealRoom Diligence can reduce your due diligence time by half. Request a demo today to learn more.