What is a business valuation?
A business valuation is an analytical process that estimates the monetary worth of an entire company or a business unit at a given point in time. It combines hard financial data (assets, liabilities, revenues, profits, cash flows) with assumptions about the future and, where appropriate, market comparables and intangible factors (brand value, customer relationships, goodwill). Valuations are used in transactions (sales, mergers, acquisitions), taxation, partner splits, financing, and legal matters such as divorce settlements.
Key principles (short)
– No single “true” number: different methods answer different questions and produce different results.
– Inputs matter: small changes to growth, margins, or discount rates can produce large valuation swings.
– Use multiple approaches: comparing results from several methods helps sanity-check a conclusion.
Common valuation methods (what each measures and when to use it)
– Market capitalization: public market method. Value = share price × shares outstanding. Quick for listed firms but ignores debt and cash. Use when you want a market-based snapshot of equity value.
– Enterprise value (EV—not listed separately above but important): EV = market cap + debt − cash. EV reflects value for all claimholders (equity + debt).
– Times-revenue (revenue multiple): Applies an industry multiple to past (or trailing) sales. Simple and commonly used for early-stage or unprofitable firms; sensitive to chosen multiple.
– Earnings multiplier (profit/earnings multiple): Applies a multiple (such as P/E or EV/EBITDA) to normalized profits or EBITDA. Better than revenue multiples when profits are stable and comparable companies exist.
– Discounted cash flow (DCF): Projects future free cash flows and discounts them to present value using an appropriate discount rate (reflects time value of money and risk). Most conceptually rigorous but sensitive to forecasts and the discount rate.
– Core formula (multi-period): PV = Σ (CFt) / (1 + r)^t, where CFt is cash flow in period t and r is the discount rate.
– Book value: Balance-sheet equity = total assets − total liabilities. Useful as a floor or for asset-heavy firms.
– Liquidation value: The net cash expected if assets were sold today and liabilities paid. Used when a company is distressed or likely to be wound up.
– Other approaches: replacement cost, breakup value, or industry-specific formulas.
How the valuation process typically works (step-by-step)
1. Define the purpose and the valuation date (transaction, tax filing, financing).
2. Gather financial statements (income statements, balance sheets, cash-flow statements) and supporting schedules.
3. Normalize earnings (adjust for owner compensation, one-offs, nonrecurring items).
4. Select methods appropriate for the company and purpose (e.g., DCF + comparable multiples).
5. Estimate inputs: growth rates, margins, capital expenditures, working capital needs, discount rate, and industry multiples.
6. Calculate values under each method.
7. Reconcile results and present a valuation range with sensitivity analysis showing how changes in key inputs affect value.
8. Document assumptions and data sources.
Short checklist (practical)
– Purpose and date defined?
– Complete, recent financial statements on hand?
– Owner/related-party adjustments applied?
– Comparable companies or industry multiples identified?
– Cash-flow projections prepared (for DCF) and discount rate selected?
– Debt, cash, and nonoperating assets accounted for (to move from equity value to EV or vice versa)?
– Sensitivity table included (e.g., ±1% discount rate, ±10% growth)?
– Supporting documentation and sources saved?
Worked numeric example: $500,000 in annual sales
Scenario assumptions (illustrative only): small private service firm with $500,000 in trailing sales, 10% net margin, and typical local-service revenue multiples of 1.0× to 1.5× sales. Also assume a reasonable earnings multiplier for similar firms is 4× normalized earnings.
1) Times-revenue method
– Multiple chosen: 1.25× sales (midpoint of 1.0–1.5)
– Valuation = 1.25 × $500,000 = $625,000
2) Earnings-multiplier method
– Net earnings = 10% of $500,000 = $50,000
– Multiple chosen: 4× normalized earnings
– Valuation = 4 × $50,000 = $200,000
Interpretation: The revenue multiple yields $625,000 while the earnings multiple yields $200,000. The gap reflects different emphases: revenue multiples value top
line without considering margins, while earnings multiples reflect profitability and cash flow. That difference explains why two standard methods can give very different answers for the same company.
Reconciling divergent valuations — step‑by‑step
1. Re-examine assumptions. Confirm the underlying inputs used by each method:
– Revenue multiple: chosen multiple, source of comparable transactions, growth assumptions.
– Earnings multiple: earnings definition (net profit, EBITDA, seller’s discretionary earnings), normalization adjustments (owner compensation, one‑time items).
– Document your sources and dates for each comparable multiple.
2. Normalize earnings. Adjust reported earnings for:
– Owner’s discretionary pay (add back excess compensation).
– Nonrecurring gains/losses (lawsuits, sale of assets).
– Related-party transactions.
This yields “normalized earnings” — the basis for earnings multiples or cash‑flow projections.
3. Choose the valuation mix. Use multiple methods, then reconcile:
– Decide which methods are most relevant for the business type (e.g., revenue multiples for early‑stage, loss‑making firms; earnings or DCF for stable, profitable firms).
– Assign weights to each method based on relevance and data quality.
– Compute a weighted/blended value.
Example using the illustrative firm (assumptions repeated for clarity): trailing sales $500,000; net margin 10% → normalized earnings $50,000; revenue multiple valuation $625,000; earnings multiple valuation $200,000.
– If you regard profitability as the stronger signal, weight earnings 70% and revenue 30%:
Blended value = 0.30×$625,000 + 0.70×$200,000 = $187,500 + $140,000 = $327,500.
– If you trust market comps for revenue more and weight each 50/50:
Blended value = 0.5×$625,000 + 0.5×$200,000 = $412,500.
Explain and document why you chose the weights.
Using DCF to cross‑check (sensitivity demonstration)
A discounted cash flow (DCF) values future free cash flows (FCF) by discounting them to present value using a required return (discount rate). A simple terminal (Gordon) perpetuity approximation is:
Value ≈ FCF1 ÷ (r − g)
where FCF1 is next year’s free cash flow, r is the discount rate, and g is long‑term growth rate.
Worked example (illustrative only)
– Normalized FCF (assume equal to normalized earnings): $50,000 (FCF1 = $50,000 × 1.03 if you expect 3% next‑year growth)
– Use g = 3% (long‑term), and try three discount rates to show sensitivity:
– r = 12%: Value ≈ 50,000×1.03 ÷ (0.12 − 0.03) = 51,500 ÷ 0.09 = $572,222
– r = 15%:
r = 15%: Value ≈ 50,000 × 1.03 ÷ (0.15 − 0.03) = 51,500 ÷ 0.12 = $429,167
r = 20%: Value ≈ 50,000 × 1.03 ÷ (0.20 − 0.03) = 51,500 ÷ 0.17 = $302,941
Quick summary of the three scenarios (company enterprise value, illustrative):
– r = 12% → $572,222
– r = 15% → $429,167
– r = 20% → $302,941
If you want a per‑share intuition, divide firm value by shares outstanding. Example (assume 10,000 shares):
– r = 12% → $57.22 per share
– r = 15% → $42.92 per share
– r = 20% → $30.29 per share
Key takeaways from this sensitivity demonstration
– Terminal‑value sensitivity: When using a perpetuity (Gordon) terminal value, the result is highly sensitive to the discount rate r, especially when r is close to g (the long‑term growth rate). Small changes in r produce large swings in value.
– Dominance of terminal value: In many DCFs the terminal value (the value after an explicit forecast period) can represent the majority of the total present value. That makes careful choice and checking of g and r critical.
– Use DCF as a cross‑check: Treat this simple perpetuity as a reality check against other approaches (comparable multiples, precedent transactions, and recent prices). Large disagreements mean re‑examine assumptions.
Practical checklist when using a DCF (or the simple Gordon shortcut)
1. Normalize FCF: Adjust one‑off items, cyclical effects, and accounting quirks so FCF reflects sustainable cash generation.
2. Choose the right discount rate: Use WACC (weighted average cost of capital) to value the whole firm, or use the cost of equity if valuing equity directly. Ensure your inputs (beta, debt cost, tax rate, target capital structure) are consistent.
3. Pick a conservative terminal method: If using Gordon growth, choose a long‑term growth rate g that does not exceed long‑run GDP/inflation expectations and is realistic for the industry.
4. Run sensitivity analysis: Vary r and g across plausible ranges (as above) and present a matrix of outcomes.
5. Cross‑check: Compare implied multiples (e.g., EV/EBITDA) to peer group averages and check reasonableness against market prices.
6. Document assumptions and breakpoints: Show how much of value comes from explicit forecast vs. terminal value and which assumptions drive most of the variance.
Common mistakes to avoid
– Using an implausibly low discount rate or high perpetual growth rate.
– Treating accounting earnings as cash without adjustments.
– Ignoring changes in working capital, capex needs, or business cycles.
– Failing to stress‑test the terminal value, which often dominates the DCF.
Brief worked sensitivity extension (optional)
– If you instead assumed 5% long‑term growth (g = 5%) with r = 12%: Value ≈ 51,
, which highlights how sensitive a DCF can be to the long‑term growth rate and discount rate. Below I finish the worked sensitivity extension, show how to compute the terminal value step‑by‑step, give a compact sensitivity table, and end with a practical checklist for closing out a valuation.
Worked sensitivity extension — step‑by‑step
1. Terminal value formula (Gordon growth / perpetuity):
TV = FCF_{n+1} / (r − g)
– FCF_{n+1} is the free cash flow in the first year after the explicit forecast (i.e., last explicit FCF × (1 + g)).
– r is the discount rate (cost of capital).
– g is the long‑term perpetual growth rate.
2. Example assumptions (for clarity):
– Last explicit‑year FCF (FCF_n) = 5 (units: millions or per‑share — be consistent).
– Compute FCF_{n+1} = 5 × (1 + g).
3. Compute terminal value for a few r / g combinations:
– Case A: r = 10%, g = 3%
• FCF_{n+1} = 5 × 1.03 = 5.15
• TV = 5.15 / (0.10 − 0.03) = 5.15 / 0.07 = 73.57
• Implied perpetuity multiple =
Implied perpetuity multiple = TV / FCF_{n+1} = 1 / (r − g).
Using the Case A numbers:
– FCF_{n+1} = 5 × 1.03 = 5.15
– TV = 5.15 / (0.10 − 0.03) = 73.571
– Implied perpetuity multiple = 1 / 0.07 = 14.29
Compute a few more r / g combinations (same last explicit‑year FCF = 5):
Case B: r = 9%, g = 1%
– FCF_{n+1} = 5 × 1.01 = 5.05
– TV = 5.05 / (0.09 − 0.01) = 5.05 / 0.08 = 63.125
– Implied perpetuity multiple = 1 / 0.08 = 12.50
Case C: r = 12%, g = 2%
– FCF_{n+1} = 5 × 1.02 = 5.10
– TV = 5.10 / (0.12 − 0.02) = 5.10 / 0.10 = 51.00
– Implied perpetuity multiple = 1 / 0.10 = 10.00
Key observations (what the numbers show)
– The terminal value depends only on the spread (r − g) and the first post‑forecast FCF. Changing r and g while keeping the spread constant produces the same implied multiple. Example: if r − g = 7%, the multiple will be ≈14.29 regardless of the individual r and
g.
That equality — same spread (r − g) ⇒ same implied perpetuity multiple (1/(r − g)) — is the key algebraic fact behind many discussions of terminal value sensitivity. It means that an analyst can change the discount rate r and the long‑term growth rate g in opposite directions and leave the terminal multiple unchanged, as long as the spread remains constant.
Continuing practical guidance and implications
1) Formula summary (reminder)
– Terminal value using the Gordon (perpetuity) formula:
TV = FCF_{n+1} / (r − g)
where FCF_{n+1} = free cash flow in the first year after the explicit forecast period, r = discount rate (usually WACC for enterprise valuation), g = perpetual growth rate.
– Implied perpetuity multiple:
Multiple = 1 / (r − g)
So TV = FCF_{n+1} × Multiple.
2) Quick worked sensitivity example (numeric)
Assume FCF_{n+1} = 5 (millions or units). Compute TV and implied multiple for a few spreads:
– Spread = 5% (0.05): Multiple = 20.0 ⇒ TV = 5 × 20 = 100
– Spread = 6% (0.06): Multiple ≈ 16.667 ⇒ TV ≈ 83.333
– Spread = 7% (0.07): Multiple ≈ 14.286 ⇒ TV ≈ 71.429
– Spread = 8% (0.08): Multiple = 12.5 ⇒ TV = 62.5
– Spread = 9% (0.09): Multiple ≈ 11.111 ⇒ TV ≈ 55.556
Takeaway: small changes in r − g produce large percentage changes in TV because multiple is 1/(r − g). For example, moving the spread from 7% to 6% raises TV by ≈16.7%.
3) Practical step‑by‑step checklist to compute a robust terminal value
– Step 1: Confirm whether you use enterprise (FCFF + WACC) or equity (FCFE + cost of equity) valuation. Match FCF type and discount rate.
– Step 2: Calculate FCF_{n+1} clearly: last forecast year FCF grown by the terminal growth rate g (or use expected stabilized FCF).
– Step 3: Choose r (WACC or cost of equity) and g (long‑run real growth plus expected inflation if using nominal figures). Ensure r and g are both nominal or both real — don’t mix.
– Step 4: Compute TV = FCF_{n+1} / (r − g). Compute implied multiple = 1/(r − g).
– Step 5: Discount TV back to present value and include in the DCF sum.
– Step 6: Run a sensitivity analysis on plausible r and g ranges and report how TV and total enterprise value change.
4) How to pick r and g responsibly (guidelines)
– Choose g 50% of total DCF value — test whether that concentration makes sense and stress‑test it.
– Double counting: projecting aggressive growth in the explicit forecast and again in terminal assumptions.
6) Recommended sensitivity analyses
– Two‑way table of r vs g that shows PV of TV and % of total enterprise value.
– Tornado chart to show which inputs (FCF forecast, r, g) drive the outcomes most.
– Scenario checks: conservative, base,