What it means
There are three broad approaches and most valuations use at least two of them. The income approach discounts expected future cash flows to a present value, the market approach applies a multiple taken from comparable companies or recent deals, and the asset approach values what the business owns less what it owes.
Valuation matters because it sets the price of nearly every significant ownership decision. It determines what a founder receives on exit, how much of a company an investor gets for their money, what a departing shareholder is bought out for, and how much goodwill sits on a buyer's balance sheet afterwards.
The single most important input is usually normalised earnings. Owner-managed businesses often carry personal expenses, above-market or below-market director salaries and one-off items, all of which must be adjusted out before a multiple is applied, or the valuation will be built on a number nobody would actually inherit.
Two adjustments cause most of the arguments in a real transaction. Small, private companies are usually discounted for lack of marketability because their shares cannot easily be sold, and minority stakes are discounted further because a minority holder cannot force a dividend or a sale.
Finally, remember the distinction between enterprise value and equity value. A multiple is normally applied to earnings before interest and tax to give enterprise value, and the seller only receives equity value, which is enterprise value after subtracting debt and adding surplus cash.
In practice
Real-world examples.
Example
A software founder raising a funding round is valued at eight times annual recurring revenue because the business grows at 45% a year and retains 95% of its customers. The investor pays $16,000,000 for a 20% stake, implying a post-money value of $80,000,000.
Example
Two brothers who jointly own a haulage company need a valuation because one is retiring. The valuer applies an asset-based approach, since the fleet and depot are worth more than the modest profit the business generates.
Example
A dispute between shareholders in a dental practice goes to an expert determination. The valuer applies a 25% discount for lack of marketability and a further minority discount to the departing partner's 15% holding.
Think of it
“Business valuation is figuring out what a company is worth-calculating the price.
Formula
Calculation
Enterprise value = normalised EBITDA x valuation multiple
Equity value = enterprise value - debt + surplus cash
A family-owned commercial cleaning company reports operating profit of $1,950,000. Adding back $300,000 of depreciation and $150,000 of an owner's salary above the market rate for the role gives normalised EBITDA of $1,950,000 plus $300,000 plus $150,000, which equals $2,400,000.
Recent sales of similar cleaning businesses have completed at around six times EBITDA. Enterprise value is $2,400,000 x 6 = $14,400,000.
The company carries $3,000,000 of bank debt and holds $500,000 of cash beyond what the business needs to operate. Equity value is $14,400,000 less $3,000,000 plus $500,000, which equals $11,900,000. That is what the shareholders would receive before fees and tax on a debt-free, cash-free sale at this multiple.Case study
Seen in the real world.
Wrenfield Joinery is a fictional company invented for this illustrative example. Its owner assumed the business was worth roughly $9,000,000 because a competitor had sold for that, and she was surprised when the first adviser she consulted suggested a range closer to $5,500,000 to $6,500,000.
The difference came from normalisation and working capital. Wrenfield's reported profit included a one-off insurance settlement of $400,000, its owner drew a salary well below what a replacement managing director would cost, and the business ran on $1,800,000 of overdraft that a buyer would treat as debt.
After correcting for those items and holding twelve months of clean management accounts, Wrenfield sold eighteen months later for $7,100,000. The lesson in this illustrative story is ordinary but frequently ignored: valuation follows the quality and clarity of the numbers at least as much as it follows the size of the profit.
Watch out
Common mistakes.
- Applying an industry multiple to reported profit without normalising it first. Owner-managed accounts are usually prepared to reduce tax, not to display a buyer's real earnings.
- Confusing enterprise value with what the shareholders actually receive. Debt comes off the top, and a headline price can shrink dramatically once borrowings are repaid.
- Assuming a valuation from a fundraising round equals the price a trade buyer would pay. Investors buy growth potential with preference rights attached, while trade buyers buy cash flow and pay accordingly.
Questions
People also ask.
Which valuation method is the most accurate?
None is definitively accurate, so valuers usually triangulate two or three methods and explain why they have weighted one more heavily than the others.
Why do private companies sell at lower multiples than listed ones?
Because their shares are harder to sell, they are usually smaller and more dependent on a few people or customers, and they carry more risk for a buyer.
Does a valuation guarantee the sale price?
No, it establishes a defensible range, and the final price depends on how many buyers are competing, how the deal is structured and how much of it is deferred.
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