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Importance of Business Valuation for Companies

By January 12, 2022June 17th, 2024Blog7 min read
Rakesh Narula - Importance of Business Finance

There’s one question every business owner should ask themselves.

“What is the worth of your company in the open market?”

Business valuation is vital for companies that are planning on selling their business, merging, acquisition, applying for a business loan, offering employees equity, or going through a significant life event. It’s essential to know your business’s actual price as it helps you understand where you stand. Business valuations form the basis of your corporate finance activity that includes mergers and acquisitions (M&As), capital raising, regulatory requirements for voluntary purposes.

Rapid globalization has created both opportunities and challenges for businesses, leading to uncertainty spread across global markets and raising awareness for the importance of independent valuations. These days, business valuation has grown more complex and challenging as valuation depends on various factors like capital, objectives, market, management, etc.

To keep it short: Business valuation is a process of determining the ‘economic worth’ of your business considering your business model, empirical evidence, and other external factors. It acts as a reality check for business owners with an unbiased viewpoint whether their business is worth surviving in the market.

Price and value are two different things as value differs w.r.t the person, time and purpose. Thus, valuation is a hybrid of art and science.

Business valuation is crucial to resolve legal or tax issues. However, valuations aren’t just limited to acquiring or selling your business. It’s a requirement during natural calamities, disability, divorce and death. This enables in knowing whether your business assets fulfil all legal filings.

Valuations are considered an essential element when you want to gift or donate company stocks for a charitable contribution, settle the shareholder’s dispute, or transform into an S-corporation. Business valuation is a requirement whether you’re planning for a partnership, buying/selling, or preparing a shareholder agreement. RNC has been empanelled and rendering plant and machinery valuation services to all major nationalized banks, financial institutions and Non-Banking Financial Corporations (NBFC) for the past three decades.

We bring to you some reasons why you need a business valuation:

  • Change in ownership due to succession or retirement
  • Giving away or gifting shares of your business to your future generation
  • Merger with another entity
  • Addition of a new shareholder
  • Increasing investment capital
  • Acquiring benefits of employee stock ownership plan (ESOP)
  • Filing for a divorce

Business Valuations Helps you to Move in the Desired Direction

Business owners may probably feel lost, but a substantial business valuation will give a clear idea of where your company stands and give you an insight into where you need to reach. It enables you to determine which areas you need to improve in order to enhance your business value.

Many business owners conduct a business valuation at the same time. They have no idea about how to improve their results. A proper valuation can help you show which areas need improvement, thus serving as a foundation for strategic decisions to develop and enhance your business. It is useful for companies of all sizes as it provides a distinct value of your ownership and business worth.

There are a few things you need to know about business valuation.

Fair Market Value-

It’s a fairly common and accepted standard defined as the “the price at which the property would change hands between the willing buyer and seller”. Here the people involved are not under any compulsion to sell and have their own reasonable reasons to make the deal. Typically, it’s used for the following situations:

  • Handing over inheritance to their respective heirs
  • Filing Internal Revenue Service (IRS) and other such transfers
  • Selling your business at an auction or on the open market

The main objective of business valuation is to seal the deal at a supportable estimate between the buyer and seller who have full knowledge of the facts. To get your business’s fair market value, you need to prepare an analysis of business tax returns for 5 years, conduct employee valuation, and the average or weighted average values determined with various valuation approaches.

Book Value-

Book value resembles the balance sheet assets irrespective of the liabilities. For instance, your company’s total assets are $100 million, and liabilities are $80 million, then the book value of your company would be $20 million. It’s a secondary approach to valuation that tests valuations of your company having significant assets, like inventory, receivables, equipment, or property.

Valuation Methods-

It is more appropriate, particularly when there are expensive assets and low profits. Thus, it may not provide an accurate indication of fair market value.

Broadly, 3 business valuation approaches are considered while conducting a valuation. Other than this, several business valuation methods, depending on your business models. The valuer can use only one method to get their value conclusion.

1. Asset-based Approach (NAV): It is used to evaluate intangible assets that a business possesses. Thus, it cannot be perceived as an accurate indicator of fair business value. NAV is considered viable for companies that have reached their matured or declining growth cycle, including property and investment companies.

2. Income-based Approach: In this method, the business is valued based on the present value of its future earnings or cash flows. It is determined by projecting the business’s earnings and adjusting it for changes in growth rates, cost structure, taxes and likewise. This method is generally used in value-based companies like engineering or healthcare companies, store chains, prospects, etc.

3. Market-based approach: Here, the value is determined by comparing the subject, assets or company based on the selling price of similar assets. It is preferable in situations where abundant data is available on comparable transactions. This approach is relatively easy to employ in residential real estate or publicly traded shares.

Also Read: Driving Factors To Boost Your Company’s Valuation.

Business Valuation in India

In India, business valuation is known as an art or science. It’s a substantial part of the litigation in Mergers & Acquisition (M&A) as it includes an element of subjectivity that is challenged often.

Also, we don’t have many regulators prescribed standards for business valuation for private and unlisted companies. In many cases, valuation lacks uniformity and universally accepted valuation practices. There are several loopholes like limited judicial guidance, absence of stringent course of action, and no statutory board regulating valuation process.

The Bottom Line!

The main objective of business valuation is to determine the key value-generating areas of your business. You need to identify the critical value-generating areas of your business to help you grow. Every business owner should know which areas of their business have a specific interest or value that can enhance its value and generate more revenue.

You need to have a distinct mindset and business objectives that are pivotal points in negotiating the final deal. It not only allows identifying the key profit driver but also settles a pinpoint for future deal negotiations.