The Main Two Methods of Valuating a Business

Whether you’re selling or buying your business, your VR Intermediary will perform a business valuation.

There are two methods that are normally used in business valuations: Multiple of Earnings and Discounted Cash Flow Approach.

Multiple of Earnings 
This method can also be used when valuing a business. Parties dealing with private businesses should also remember that most are likely to be subject to a much lower price-to-earnings ratio than a publicly-held corporation because the smaller business does not represent the same liquidity as an investment in public stock. Therefore, if public comparable Price to Earning (P/E) multiples are used to estimate the value of a private corporation, these multiples are usually discounted.

Discounted Cash Flow Approach
This is usually based on a projection of earnings for 3 to 5 years and the resulting cash flows for each year. In turn, these cash flows are discounted to their present value at an appropriate discount rate, depending on the buyer’s perception of risk in the business.

Remember that a person expects a return from buying a business that is comparable to the returns that they could realize on other investments of similar risk. To assess the risk(s) and determine an appropriate rate of return, a buyer should consider such factors as the credibility of pro forma projections of sales and earnings, the risk inherent in the target company’s industry and the weighted average cost of capital, taking into account both the cost of debt and of equity.

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