Business Valuation Process: Steps to Evaluate a Business

Selling a business without knowing its worth is like negotiating a price with no idea where to start. A business valuation determines the worth of your company by examining its financial performance, assets, earning potential, market conditions, and risks. But arriving at that number takes more than looking at annual revenue or applying a standard multiple.

The business valuation process looks at financial records, normalized earnings, business operations, industry conditions, and future earning potential to develop a defensible estimate of value.

The purpose of the valuation also matters. Valuators assess a business differently depending on whether the owner plans to sell it, transfer ownership, secure financing, or address a tax matter.

7 Steps in the Business Valuation Process

1. Define the Purpose and Valuation Date

Before valuing a business, the valuator needs to establish why the valuation is needed and the date it should reflect.

The purpose can affect how the valuator approaches the assignment. A valuation for a business sale requires different considerations from preparation for an ownership transfer, tax matter, financing, or legal proceeding.

The valuation date matters because business value can change over time. Changes in revenue, customers, market conditions, debt, or other circumstances affect the business's worth on a particular date.

In simple terms, the valuator establishes what is being valued, why it is being valued, and the date the valuation should reflect.

2. Gather Financial and Business Information

Next, the valuator collects the information needed to understand how the business makes money, what it owns, and what could affect its value.

This usually includes:

• Financial statements and tax returns
• Revenue and expense records
• Assets and liabilities
• Business debt
• Customer and supplier information
• Employee and management details
• Major contracts and agreements
• Business plans and financial projections

The more complete the information, the more reliable the valuation analysis can be. Missing records or important business details make it difficult to identify risks, adjust financial results, or properly assess the company's performance.

3. Review and Normalize Financial Statements

Reported financial results do not always show how a business performs under normal conditions. This is especially common in small, owner-operated businesses where personal expenses, unusual costs, or owner compensation run through the company.

The valuator reviews the financial statements and adjusts items that do not reflect the business's ongoing performance. These include:

• Owner compensation that differs from market levels
• Personal or discretionary expenses
• One-time legal or moving costs
• Unusual gains or losses
• Transactions with related parties that are not at market rates

These adjustments are known as normalizing the financial statements. The goal is to show what the business could reasonably earn under normal operating conditions.

For smaller businesses valuation, the valuator uses Seller's Discretionary Earnings (SDE). For larger companies with a management team, normalized EBITDA is appropriate.

Normalization matters because even a relatively small adjustment affects the final value when the business is valued using an earnings multiple.

4. Analyze the Business and Its Industry

Once the financials are clear, the valuator looks at the bigger picture. The goal is to understand how the business performs, what drives its revenue, and what could affect its future value.

The analysis covers:

• Revenue and profit trends
• Customer and supplier concentration
• Competitive position
• Industry conditions and growth
• Dependence on the owner or key employees
• Pending legal or regulatory issues
• Major contracts and lease obligations

Two businesses can have similar revenue and profits but very different values. A company that depends heavily on one customer or its owner carries more risk than one with a diversified customer base and experienced management.

The valuator considers current market and industry conditions because business values and comparable transaction multiples change over time.

5. Select the Appropriate Valuation Method

After reviewing the financials, business, and industry, the valuator chooses the most appropriate way to calculate value.

The three main valuation approaches are:

• Income approach: Estimates value based on the business's expected future earnings or cash flow.
• Market approach: Compares the business with similar companies or recent transactions.
• Asset approach: Determines value based on the company's assets and liabilities.

The right approach depends on factors such as the company's size, industry, financial performance, available information, and the purpose of the valuation. In some cases, the valuator uses more than one approach and compares the results.

6. Calculate the Business Value

The valuator then applies the selected method to the company's normalized financial results to calculate an initial indication of value.

For example, an income-based valuation uses expected cash flow or normalized earnings, while a market-based valuation applies a multiple based on comparable businesses or transactions.

If the valuator uses more than one method, they do not simply average the results. Instead, they consider how relevant and reliable each result is for the specific business before reaching a preliminary value.

7. Make Adjustments and Determine the Final Value

The initial value calculated in Step 6 may not be the final business value. The valuator reviews the result and makes adjustments that reflect the company's actual financial position and the ownership interest being valued.

Common adjustments include:

• Debt and cash: Adjusting for interest-bearing debt and excess cash to move from enterprise value to equity value.
• Non-operating assets: Separately accounting for assets such as investments, unused real estate, or equipment that the business does not need for daily operations.
• Working capital: Checking whether the business has the level of working capital needed to continue normal operations.
• Ownership interests: Applying relevant discounts when valuing a minority or less-marketable ownership interest.

After considering these adjustments, the valuator reconciles the results and reaches the conclusion of value that appears in the valuation report.

What Information Is Needed for a Business Valuation?

A valuator needs enough information to understand the company's financial position, operations, assets, and risks. The exact requirements vary by business, but most valuations require these categories:

• Financial records: Income statements, balance sheets, cash flow statements, and current-year financials.
• Tax returns: Recent business tax returns to verify financial information and identify items that need adjustment.
• Assets and liabilities: Details about equipment, inventory, real estate, loans, leases, and other liabilities.
• Business operations: Information about employees, management, ownership, and how the business operates day-to-day.
• Customer and revenue information: Revenue by customer or product, customer concentration, and major revenue trends.
• Contracts and supporting documents: Important customer and supplier agreements, leases, licenses, buy-sell agreements, and other documents that could affect value.
• Debt and cash: Adjusting for interest-bearing debt and excess cash to determine the value attributable to the owners.

Having these records organized from the start can speed up the valuation process and reduce unnecessary follow-up.

Common Mistakes That Can Affect a Business Valuation

The accuracy of a valuation depends heavily on the information and decisions made throughout the process. Common mistakes include:

Providing incomplete financial information: Missing records can prevent the valuator from getting a complete picture of the company's performance.

Failing to normalize financial results: One-time expenses, personal costs, or unusual transactions can distort earnings if the valuator does not identify and adjust them.

Using an inappropriate valuation method: A method that does not fit the company's size, industry, financial performance, or valuation purpose can produce an unreliable result.

Overlooking business risks: Customer concentration, owner dependency, key employees, supplier relationships, and industry conditions can all affect value.

Using the wrong valuation date: Business value can change over time, so the analysis must reflect the agreed valuation date.

Relying on unsupported assumptions: Financial projections and adjustments should have reasonable support rather than relying on estimates or rules of thumb.

Get a Clear Picture of Your Business’s Value

A business valuation evaluates your financial performance, assets, earnings potential, industry conditions, and business risks to determine what your company is worth. Following the right process also helps ensure that the final value reflects the business accurately rather than relying on a simple revenue figure or rule-of-thumb multiple.

If you are preparing to sell your business, planning an ownership transition, seeking financing, or making another major business decision, a professional business valuation can give you a reliable basis for your next step.

Ready to determine what your business is worth? Get your business valuation started with an experienced valuation professional.