4 Key Business Valuation Models for Mergers and Acquisitions
When it comes to valuations, no single business valuation model is perfect for every industry or business, and choosing the best model from a cluster can be overwhelming. But don’t worry—making this critical decision doesn't have to be a chore anymore!
We’ll guide you through the decision, helping you find the most suitable one so you can set up your business for future growth or a successful exit.
Here's an in-depth guide to different valuation models and some corresponding valuation methods. We'll also discuss the importance of evaluating your business, how to evaluate it, and how you can find the best M&A experts to help you.
TL;DR - Business Valuation Models
Below is a quick list of the four main business valuation models before we discuss them further in a later section:
Market-Based Model
Asset-Based Model
Earnings-Based Model
Income-Based Model
A business valuation can help you make the best decisions for the future of your business, including a potential exit.
At Exitwise, we can help you make crucial valuation-related decisions to maximize your business's value or even sell it at a significant profit. Schedule a chat with our team today to hire the best M&A experts.
Importance of Valuation for Business Owners and Investors
Business valuations offer crucial benefits to both investors and business owners. Let's check out a few:
Making Informed Decisions: A valuation assesses a business's risk and potential rewards. Investors gauge these risks and rewards to decide whether investing in your business is worth it. As the owner, you can use valuations to determine the best time to sell your business or how you can lower the risks to attract investors.
Negotiating Fair Pricing: Valuations enable business owners and potential buyers to negotiate an ideal sale price in an M&A process if they agree or harmonize their valuation reports.
Performance Monitoring: Investors can see how a business grows over time before deciding whether to buy it. As an owner, you can see what needs improving to increase the value of your business.
Raising Capital: Once the company's potential is verified, an accurate valuation can help both owners and potential investors seek or dedicate funds.
4 Key Business Valuation Models for Mergers and Acquisitions
Let's discuss the four most common valuation models in M&A:
1. Market-Based Model
The market-based valuation model considers the prevailing valuation ranges or sale multiples in a given industry.
You can use either the comparable company analysis or precedent transactions analysis:
The comparable company analysis compares your company with similar ones in your industry to see their valuations or valuation multiples.
Using this method, you can compare valuation multiples such as revenue, EBITDA, and SDE.
For example, if your company has $2 million in annual earnings and the prevailing industry EBITDA multiple is 10x, it can sell at $20 million.
The precedent transactions analysis analyzes the past valuation and exit multiples of companies recently sold in the same industry.
You can then make a judgment of your business's worth based on the multiples that correspond with the financial metrics you have.
The market-based model is ideal as a checkpoint for other valuation models, showing whether their outcomes align with current market trends.
2. Asset-Based Model
You can use the asset-based model if your business isn't highly profitable yet and has much of its worth tied to net assets and total liabilities.
The method considers all of a company's assets and liabilities at their market value as of the date of the valuation:
Business Value = Net assets (at market value) - Net liabilities (at market value)
One way to increase your business's future growth prospects and sale price is to reduce its dependence on you as the owner or operator or other key employees.
3. Earnings-Based Model
The earnings-based model offers a way to assess your business's past and future ability to generate cash flows or earnings (profits).
You can use this model if your business has significant expected future earnings, meaning it is highly likely to earn returns on the assets you use in your operations. Your current earnings should also be stable and with minimal downward changes year over year.
The capitalized cash flow (CCF) earnings method is common under this model, using a market-derived capitalization rate to convert the annual cash flow to its present value:
Business Value = Annual cash flow ÷ Capitalization rate
4. Income-Based Model
Under the income-based model, you estimate the value of a business based on its future income potential, where ‘income’ refers to ‘gross income’ after you've accounted for the costs related to producing goods or services.
The DCF is the most popular method under this model. It uses a discount rate to show the present value of projected future cash flows.
The DCF uses the formula below:
DCF = CF₁ ÷ (1 + r)¹ + CF₂ ÷ (1 + r)² + … + CFₙ ÷ (1 + r)ⁿ
Where;
CF₁ = Cash flow for year one
CF₂ = Cash flow for year two
CFₙ = Cash flow for additional years
r = The discount rate
Essential Valuation Methods and Techniques
In this section, we'll briefly discuss some valuation techniques and methods using the four models mentioned earlier:
Revenue Multiple Method
Here’s how to evaluate a business using the revenue multiple method under the market-based valuation model:
Assuming similar businesses have recently sold at an average revenue multiple of 0.52x and your business's average annual revenue is $1.5 million,
Business Value = Average annual revenue x Average revenue multiple
= $1.5 million x 0.52 = $780,000
Net Assets Method
The net assets or asset accumulation method uses the formula:
Business Value = Net assets - Net liabilities
Assuming you have $5 million in net assets and $2 million in net liabilities, your business's value is $3 million.
Capitalized Earnings Method
Here’s how to evaluate a company's value using the capitalized earnings method under the earnings-based model:
Business Value = Annual cash flow ÷ Capitalization rate
The capitalization rate is a market-derived metric that uses a business’s current annual cash flow to estimate its present value, representing the rate of return an investor can expect from the business.
If your business's projected annual free cash flow is $20 million and the market projects a 10% return on such investments,
Business Value = $20 million ÷ 10% = $200 million
Discounted Cash Flow Method
Let’s assume a company has the following financial metrics:
Year 1 cash flow = $3,400,000
Year 2 cash flow = $3,700,000
Discount rate, r = 4.5% (0.045)
Here’s how to evaluate the company's worth:
DCF = CF₁ ÷ (1 + r)¹ + CF₂ ÷ (1 + r)² + … + CFₙ ÷ (1 + r)ⁿ
DCF = $3,400,000 ÷ (1 + 0.045)^1 + $3,700,000 ÷ (1 + 0.045)^2
DCF = $3,253,588 + $3,388,200 = $6,641,788
The business value would be $6,641,788.
Criteria to Choose a Business Valuation Model
Many factors go into choosing a business valuation, including:
Owner-Operator Dynamics: If your business is too dependent on you as the owner or another operator, its value is generally lower. In this case, any goodwill the business may have is personal and tied to you or the operator. The asset-based model is ideal in this situation, even when your profitability is solid.
External Information Available: If you want to use the market comparables model to see whether your valuation is within the prevailing ranges, you must have enough high-quality external data. Such data includes the valuations and sale multiples for recently sold companies.
Business Stage: The development stage of your business can inform the valuation model you choose. For example, if you are already generating significant cash flows year over year, you can use the discounted cash flow method under the income-based model.
Industry Standards: Different industries typically have a conventional valuation model. For example, the technology startup industry usually uses revenue multiples, while the service-based industry usually uses EBITDA multiples.
How to Value a Company - Step-by-Step Process
Here are the steps to value your company accurately:
1. Collect Financial Information
You'll need your company's past or historical financial data to understand its patterns and stability across revenues, expenses, assets, taxes, and liabilities.
Gather internal financial statements and details for the past 3-5 years, including cash flow statements, tax records, income statements, and balance sheets.
You'll also need to gather external financial information, such as industry valuation multiples, to compare your company's financial health and valuation against its peers.
2. Assess Your Company's Financial Health and Performance
Use the data from step one to analyze key metrics such as net income, expenses, and profit margins to see how much your business earns.
You can also assess revenue growth over the years to project its future growth.
In addition, check your company's financial leverage by analyzing its debt-to-equity ratio.
3. Choose Several Valuation Methods
You'll want to use multiple valuation methods to better understand how much your company is worth.
The most common methods include discounted cash flow, capitalized earnings, and asset accumulation.
4. Apply the Valuation Methods
Use the corresponding formulas for the chosen valuation methods to calculate business value.
5. Factor In Qualitative Aspects
A huge mistake some owners make is leaving out qualitative aspects when valuing a company.
You should consider factors such as owner-operator involvement, prevailing industry trends, the quality of your company's management, and your competitive advantage.
6. Analyze and Interpret Results for Adjustments
For this last step, perform a sensitivity analysis where applicable to see how different assumptions can affect the valuation.
For example, using the DCF formula, you can adjust the discount rate to higher or lower levels to see how a perceived higher or lower risk level could affect the value.
You can also review and explain the differences in the various values obtained from different methods before you declare a final valuation range in your report.
Work with Exitwise to Hire the Best M&A Experts for Your Business
Assessing your business, deciding on the best valuation model, and calculating its value can be stressful.
In addition, finding the right M&A experts on your own can be confusing and time-consuming. But you don't have to do all these things yourself.
At Exitwise, we can help you find and work with the best M&A experts in your industry. Here's how our proven system works:
Chat with the Exitwise Team: When you contact our team, we'll listen to learn about your business and goals and answer all your questions regarding future growth or exit.
Connect You with Top M&A Experts: We will show you the top M&A professionals in your industry. We'll help you review and choose the ones best suited to your needs and then connect you with them.
Negotiating, Hiring, and Working with Experts: We’ll negotiate engagement terms and fees with each expert on your behalf. We'll help you hire the most suitable, after which we will help you manage and work with them until you attain your goal.
You can rely on our proven system and professional team to achieve the exit of your dreams. Reach out to us today to get started!
Frequently Asked Questions (FAQs)
Let's wrap this up with a few common questions about business valuation models:
What Factors Influence Business Valuation the Most?
Internal factors that influence business valuations the most include owner-operator involvement, overall financial health, the quality of management and other employees, and a company's development stage.
External factors that influence valuation the most include the state of the M&A market and the general economic outlook.
When you work with Exitwise, we help you choose M&A experts who can help you address critical factors to ensure your business valuation remains high over time.
How Can Valuation Techniques Vary By Industry?
Industry valuation techniques differ across industries, depending on the state of the industry, valuation purpose, and the state of the individual business.
For example, asset-based valuations are ideal for manufacturing and real estate companies because they typically have significant tangible assets, but their revenues and profits aren't up to par yet.
What Valuation Criteria Should Be Used for Small Businesses?
When valuing a small business, critical criteria can include revenue and cash flow growth year over year, profit margins, the level of involvement as the owner or operator, and customer distribution.
An increase in revenues, cash flows, and profit margins can signal better future performance, while too much owner involvement and poor customer distribution can indicate higher risks.
Conclusion
Choosing the best business valuation model can be tricky since every business is unique. Exitwise can help you recruit and work with top M&A experts to help you choose the best model, value your business, and offer insights for better future growth.
Additionally, these experts can help you sell your business faster and at the best sale price if you are looking to exit. Let’s connect today so we can connect you with the best M&A experts to secure your business's future growth and successful exit.
