What's more, knowing how to value your business becomes increasingly important as it grows, especially if you want to raise capital, sell a portion of the business, or borrow money.
Here, we'll take a look at different factors to consider when valuing your business, common equations you can use, and high-quality tools that will help you crunch the numbers.
Table of Contents
What is a business valuation?
As the name suggests, a business valuation determines the value of a business or company. During the process, all areas of a business are carefully analyzed, including its financial performance, assets and liabilities, market position, and future growth potential.
Ultimately, the goal is to arrive at a fair and objective estimate which can be useful in making business decisions and negotiating.
How to Value a Business
- Company Size
- Market Traction and Growth Rate
- Sustainable Competitive Advantage
- Future Growth Potential
1. Company Size
Company size is a commonly used factor when valuing a company. Typically, the larger the business, the higher the valuation will be. This is because smaller companies have little market power and are more negatively impacted by the loss of key leaders. In addition, larger businesses likely have a well-developed product or service and, as a result, more accessible capital.
Is your company earning a profit?
If so, this a good sign, as businesses with higher profit margins will be valued higher than those with low margins or profit loss. The primary strategy for valuing your business based on profitability is through understanding your sales and revenue data.
Valuing a Company Based On Sales and Revenue
Valuing a business based on sales and revenue uses your totals before subtracting operating expenses and multiplying that number by an industry multiple. Your industry multiple is an average of what businesses typically sell for in your industry so, if your multiple is two, companies usually sell for 2x their annual sales and revenue.
3. Market Traction and Growth Rate
When valuing a company based on market traction and growth rate, your business is compared to your competitors. Investors want to know how large your industry market share is, how much of it you control, and how quickly you can capture a percentage of the market. The quicker you reach the market, the higher your business’ valuation will be.
4. Sustainable Competitive Advantage
What sets your product, service, or solution apart from competitors?
With this method, the way you provide value to customers needs to differentiate you from the competition. If this competitive advantage is too difficult to maintain over time, this could negatively impact your business' valuation.
A sustainable competitive advantage helps your business build and maintain an edge over competitors or copycats in the future, pricing you higher than your competitors because you have something unique to offer.
5. Future Growth Potential
Is your market or industry expected to grow? Or is there an opportunity to expand the business' product line in the future? Factors like these will boost the valuation of your business. If investors know your business will grow in the future, the company valuation will be higher.
The financial industry is built on trying to accurately define current growth potential and future valuation. All the characteristics listed above have to be considered, but the key to understanding future value is determining which factors weigh more heavily than others.
Depending on your type of business, there are different metrics used to value public and private companies.
Public Versus Private Valuation
Public Company Valuation
For public companies, valuation is referred to as market capitalization (which we’ll discuss below) — where the value of the company equals the total number of outstanding shares multiplied by the price of the shares.
Public companies can also trade on book value, which is the total amount of assets minus liabilities on your company balance sheet. The value is based on the asset’s original cost less any depreciation, amortization, or impairment costs made against the asset.
Private Company Valuation
Private companies are often harder to value because there's less public information, a limited track record of performance, and financial results are either unavailable or might not be audited for accuracy.
Let's take a look at the valuations of companies in three stages of entrepreneurial growth.
1. Ideation Stage
Startups in the ideation stage are companies with an idea, a business plan, or a concept of how to gain customers, but they're in the early stages of implementing a process. Without any financial results, the valuation is based on either the track record of the founders or the level of innovation that potential investors see in the idea.
A startup without a financial track record is valued at an amount that can be negotiated. Most startups I've reviewed created by a first-time entrepreneur start with a valuation between $1.5 and $6 million.
All the value is based on the expectation of future growth. It's not always in the entrepreneur’s best interest to maximize its value at this stage if the goal is to have multiple funding rounds. The valuation of early-stage companies can be challenging due to these factors.
2. Proof of Concept
Next is the proof of concept stage. This is when a company has a handful of employees and actual operating results. At this stage, the rate of sustainable growth becomes the most crucial factor in valuation. Execution of the business process is proven, and comparisons are easier because of available financial information.
Companies that reach this stage are either valued based on their revenue growth rate or the rest of the industry. Additional factors are comparing peer performance and how well the business is executing in comparison to its plan. Depending on the company and the industry, the company will trade as a multiple of revenue or EBITDA (earnings before interest, taxed, depreciation, and amortization).
3. Proof of Business Model
The third stage of startup valuation is the proof of the business model. This is when a company has proven its concept and begins scaling because it has a sustainable business model.
At this point, the company has several years of actual financial results, one or more products shipping, statistics on how well the products are selling, and product retention numbers.
Depending on your company, there are a variety of equations to use to value your business.
Company Valuation Methods
Let’s take a look at some of the formulas for business valuation.
Market Capitalization Formula
Market Value Capitalization is a measure of a company’s value based on stock price and shares outstanding. Here is the formula you would use based on your business’ specific numbers:
Multiplier Method Formula
You would use this method if you’re hoping to value your business based on specific figures like revenue and sales. Here is the formula:
Discounted Cash Flow Method
Discounted Cash Flow (DCF) is a valuation technique based on future growth potential. This strategy predicts how much return can come from an investment in your company. It is the most complicated mathematical formula on this list, as there are many variables required. Here is the formula:
Here are what the variables mean:
- CF = Cash flow during a given year (can include as many years as you’d like, simply follow the same structure).
- r = discount rate, sometimes referred to as weighted average cost of capital (WACC). This is the rate that a business expects to pay for its assets.
This method, along with others on this list, requires accurate math calculations. To ensure you’re on the right track, it may be helpful to use a calculator tool. Below we’ll recommend some high-quality options.
Business Valuation Calculators
Below are business valuation calculators you can use to estimate your companies value.
This calculator looks at your business' current earnings and expected future earnings to determine a valuation. Other business elements the calculator considers are the levels of risk involved (e.g., business, financial, and industry risk) and how marketable the company is.
EquityNet's business valuation calculator looks at various factors to create an estimate of your business’s value. These factors include:
- Odds of the business' survival
- Industry the business operates in
- Assets and liabilities
- Predicted future revenue
- Estimated profit or loss
ExitAdviser's calculator uses the discounted cash flow (DCF) method to determine a business’s value. To determine the valuation, "it takes the expected future cash flows and ‘discounts' them back to the present day.”
Company Valuation Example
It may be helpful to have an example of company valuation, so we’ll go over one using the market capitalization formula displayed below:
Shares Outstanding x Current Stock Price = Market Capitalization
For this equation, I need to know my business’s current stock price and the number of outstanding shares. Here are some sample numbers:
Shares Outstanding: $250,000
Current Stock Price: $11
Here is what my formula would look like when I plug in the numbers:
250,000 x 11
Based on my calculations, my company’s market value is 2,750,000.
Back to You
Whether you’re looking to borrow money, sell a portion of your company, or simply understand your market value, understanding how much your business is worth is important for your business’ growth.