Here’s How Valuation Works—And Why It’s So Important

By QuickBooks

4 min read

Many business owners assume they should only care about how much their business is worth if they’re looking to sell or are going through a difficult situation, such as a divorce or corporate breakup. Unfortunately, this is an extremely shortsighted view that misses the bigger picture.

Every single business owner should know how much their business is worth, because it’s the only measure that takes into consideration where your company has been, where it is today and, most importantly, where it’s going in the future.

It may be surprising, but in my opinion, valuation is the single most important concept in finance, and it’s something that every business owner should know something about. At the end of the day, each of us is in business to create value. And your company’s value captures nearly everything about your business in one easy-to-understand number.

Valuation has a reputation for being boring, abstract and complex, and to be honest, it tends to be. But fear not, dear reader, I’ve boiled it down to make it easy for you to calculate for yourself.

Valuation Methodology: Calculating Your Company’s Worth

We’ll start with a simple definition: valuation is the price that a reasonable person would pay to own the future cash flows of a business less any debt owed plus all cash on hand. There are a number of different ways to calculate the value of a business, but the two most common methods are the discounted cash flow and market multiple methods.

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Under the discounted cash flow method, or “DCF” for short, you try to estimate the business’ future cash flows and determine how much they’re worth today. The important thing is that we now understand that when using the discounted cash flow method, the value of your business is based on two things:

  1. The cash flows you think you’ll generate in the future.
  2. The reasonable rate of risk-adjusted return you require to earn on those cash flows.

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Once you estimate the cash flows and determine an appropriate discount rate, you simply utilize the present value concept to calculate the value of the cash flows. Present value is simply the value of future cash flows discounted back to today. In other words, what would you pay today for a dollar that will be given to you one year from now? The farther out the cash flow, the more of it is discounted because there’s more uncertainty related with it. From there, you subtract all of the debt that you owe and add in any cash on hand to arrive at the value of the business.

Another easier-to-calculate approach to valuing your business is called the market multiple method. In this method, we don’t worry about projecting cash flows or figuring out what a reasonable rate of return might be. Instead, we look at businesses that have actually sold and compare the sales price to a metric in the business, such as revenue or earnings. Let’s look at another slightly simpler example.

Let’s say that you own a restaurant, and you want to know how much it’s worth. You know that a similar restaurant in your city recently sold for $1 million dollars and had about $200,000 in earnings. The market multiple for this business is calculated by taking the sales price of $1 million and dividing it by the earnings of $200,000. In this case, the multiple is five-times earnings. So, using this estimate, you’d simply multiply your earnings by five, subtract debt and add cash to figure out what your company might be worth.

Which Approach Is Better?

There are benefits and drawbacks to both approaches. The discounted cash flow model, while complicated, does a really great job of capturing the specific story of your business and, more importantly, the direction you think it’s headed. The problem is that it’s really hard to predict the future accurately. It’s even harder to figure out what a reasonable rate of return would be for your business.

The market multiple approach, on the other hand, does a pretty good job of estimating what people are actually paying when buying businesses. Unfortunately, it doesn’t take into account the specifics of your company, such as your unique cost structure, and it isn’t forward-looking. Best practice is to use both and weight them according to how confident you are in each. That way, you get the best of both worlds and can arrive at a reasonable value for your business.

Value-Based Management: Why You Should Care

Obviously, if you are selling your business, valuation is extremely important. However, valuation can and should be used as a powerful driver of how you manage your business. The purpose of this estimated value is to track the effectiveness of your strategic decision-making process and to provide you with the ability to track performance in terms of estimated change in value, not just in revenue.

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This helps you to take a holistic look at your business and make decisions that are highly impactful for your bottom line. It allows you to understand the subtle dynamics of your business and avoid unforeseen consequences of seemingly reasonable decisions. A value-based management approach will set you apart from your competition and dramatically change the way you and the market view your company.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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