What Is a Business Valuation, and How Do You Calculate It?

How do you put a price on the time, effort, and passion you've invested into building a successful small business? It can be hard to objectively assess how much your venture is worth after putting so much work in over the years.

This is where business valuation calculations, ideally handled by a third-party expert, can play a role. Business valuations are used for mergers, acquisitions, tax purposes, litigation, and more. Here's how business valuations work and how to calculate the economic value of your company.

[Read more: 6 Things to Consider Before Selling Your Business]

What is a business valuation?

A business valuation assesses the economic value of part or all of a business. Business valuations are used in a number of circumstances, including determining the sale value of a business, establishing partner ownership, for tax purposes, and even in divorce proceedings.

Generally, the valuation process analyzes all aspects of the business, including the company's management, capital structure, future earnings, and the market value of its assets. In the United States, business valuations are usually carried out by a professional who is Accredited in Business Valuation (ABV). This certification, awarded by the American Institute of Certified Public Accountants (AICPA), is given to CPAs who pass an exam and meet standards set by the AICPA.

If you're seeking financing from lenders, investment bankers, or venture capitalists, you may need an ABV-certified professional to conduct your business valuation. If you're simply looking to understand how much your venture is worth, you can do your own analysis using one of the business valuation methods listed below.

[Read more: How to Calculate a Business Valuation]

Business valuation methods

There are three common methods for evaluating the economic worth of a business. These categories are:

• Asset-based methods: A sum of all the investments in the company to determine the value of the business.
• Earning value methods: The company’s ability to produce wealth in the future.
• Market value methods: What the company is worth based on similar businesses that have recently been sold.

There are pros and cons to each of these valuation approaches. An asset-based approach, for instance, works well for corporations in which all assets are owned by the company and will be included in the sale. However, for a sole proprietor, this approach can be more difficult — which assets should be considered personal versus business-related?

Generally, the two main earning value methods — capitalizing past earnings and discounted future earnings — are used when a company is seeking to buy or merge with another company. Market-value approaches are the least accurate and can lead to a business being under or overvalued.

What you need to value a business

Before you calculate your business’s value, make sure you have the right information. Key documents you’ll need include: 

• Profit and loss statements from at least three years
• Balance sheets
• Cash flow statements
• Tax returns
• Inventory lists (that show equipment, property, etc.)
• Key customer metrics, such as retention rate and revenue
• Outstanding liabilities 
• Patents or trademarks

These are the core tangible documents to help you assess your company’s worth. Of course, intangible factors play a role in the final figure, such as market trends, geopolitical and economic stability, and brand recognition.

How to calculate a business's value

Often, business valuations are performed by a licensed professional. To find an ABV who can help, look for someone registered with the AICPA or a member of the American Society of Appraisers accredited in business valuation.

If you simply want to get a basic idea of what your business is worth, you can take a few steps to get a rough estimate. Start by calculating your seller's discretionary earnings (SDE). SDE is like earnings before interest, taxes, depreciation, and amortization (EBITDA), but it adds the owner's salary, benefits, and any discretionary or nonrecurring spending.

To calculate the SDE, start with your net income. Next, add compensation paid to owners (including salary, profit sharing, cash distributions, etc.), benefits, depreciation and amortization, nonrecurring expenses (like legal fees or a one-time marketing expense), personal expenses (like travel or vehicles), followed by interest and taxes.

Once you have your SDE, take stock of your assets, do some competitive research to see what similar businesses have sold for, and pay attention to industry trends to see if you can ask for a higher valuation.

Try to use multiple methods to get the most accurate estimate of your business’s value. Running the calculations using three different methodologies can give you a more accurate estimate of the fair market value of your company. 

The role of financial projections in business valuation

Many methods used to evaluate the worth of a business require financial projections. These reports provide insight into a company’s potential value by estimating revenues, expenses, and other key financial metrics.

"Financial projections encompass several essential components that contribute to a comprehensive evaluation of a business," wrote Equitest, a valuation platform. "These components include revenue forecasts, expense forecasts, cash flow forecasts, and balance sheet forecasts."

These estimates give investors and lenders deeper insight into a company's financial health, including the risks and potential opportunities to be gained by committing capital. However, reliable and effective financial projections require careful consideration. Overestimating a company's worth can lead to investor losses, shareholder frustration, and, potentially, litigation.

[Read more: How to Write a Financial Forecast for Your Business]

How to increase your business valuation

There are several ways to increase your company's value. Most methods focus on building a strong, sustainable foundation of profitability. It takes careful planning and preparation, rather than cosmetic changes, to ensure your business gets the maximum value in a sale.

Start by working on boosting profitability. Look for ways to increase sales while simultaneously becoming more operationally efficient.

"Focus on creating a diversified customer base that, ideally, generates recurring revenues," wrote the BDC.

Also, invest in building a strong brand identity that fosters greater customer loyalty. Some of the most valuable companies in the world also have valuable brand identities. Building your brand value involves marketing, providing great customer service, and creating a memorable experience that boosts customer loyalty.

There's no silver bullet when it comes to increasing your business’s value. However, an outside adviser can help you assess where your business can improve to increase its worth. Spend some time auditing your strengths and weaknesses before attempting a merger or sale.

How does purpose influence valuation? 

This guide outlines the three common ways to value a business. There are others, however, that might be more appropriate depending on your purpose or your business type. For instance, asset-heavy businesses, such as those in manufacturing or real estate, tend to use book value, a method that measures your company's net worth based on its balance sheet.

However, if you’re in the process of fundraising, investors prefer revenue multiples, a method that calculates your company's worth as a multiple of annual sales.

“Estimating the fair value of a business is both an art and a science. Choosing the right method and appropriate inputs can be subjective or vary based on industry standards,” wrote Investopedia.

There’s no single best way to calculate your business’s value. The factors you should consider include:

• Business size, stage, and stability. For instance, early stage businesses benefit from revenue multiples, whereas mature, profitable businesses benefit from income methods.
• Earnings and asset profile. Strong, predictable earnings with few assets support income approaches, whereas companies that are asset-heavy should use an asset-based approach.
• How much data you have. If you have weak forecasts, lean on simple multiples or an asset-based approach. If you have clean financials, use a capitalization method.
• Who the buyer is. Investors will be focused on hard financial results, whereas a strategic buyer will be interested in market comps.

Again, use two or three valuation methods to get a broader picture of what your business might be worth. Working with a professional appraiser is also smart. 

When to hire a professional appraiser (and what it costs)

“Selecting the right business valuation expert can be a bit tricky. There’s no business valuation-specific college major, and states don’t require a specific license to practice business valuation,” wrote SCORE. “You’ll see an alphabet soup of business valuation credentials, such as ASA, ABV, CVA, and CBA.”

The first step for finding an appraiser should be visiting the American Society of Appraisers’ website. They have a database of accredited business appraisers. The National Association of Certified Valuation Analysts (NACVA) also offers a free online directory.

Because there are so many different certifications, the cost of a business appraiser varies widely — from $5,000 to $20,000 and up. Many charge an hourly rate, so be well prepared with the right documentation to ensure the process goes smoothly. 

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation. 

CO—is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the U.S. Chamber of Commerce, here.