How Does Business Valuation Work?

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Every year, thousands of businesses across the United States are valuated. Valuations happen for a wide variety of reasons. In some cases, businesses receive a valuation because they are being privately sold. In other cases, valuations take place when a business decides to hold an initial public offering (IPO). Finally, valuations can also take place for insurance purposes. While valuation may take place for many different reasons, the process that auditors use to determine the value of a business is usually the same. The following guide explores how business valuation works. 

Business valuation is based on four main areas. These include revenue, assets, liabilities, and costs. When businesses receive a valuation, auditors look at these four factors when determining a company’s value. 

Revenue 

Revenue includes all the money that a business is able to generate. This could include money from selling products or services. It is the net amount of money that a business is able to generate. Revenue doesn’t include any costs. It only includes the raw amount of money a company is able to generate. 

Costs 

Costs include all the daily expenses that a business requires for successful operation. This includes the cost of staff, raw materials, insurance, rent, and much more. When costs are lower than revenue, a business is able to generate a profit. 

Some companies are able to generate significant amounts of revenue without generating a profit. For example, some drop shipping companies will resell products or services with only a very small profit. However, they are often able to make up for small individual profits with a higher volume of transactions. 

Assets 

Assets include everything that a business owns. This could include bank accounts, physical assets, intellectual property, equipment, real estate, licensing arrangements, royalties agreements, and much more. Assets represent all the value that a company has been able to build up over the years. However, it’s important to remember that the value of any assets must be weighed against a company’s liabilities, which are explained below. 

Liabilities 

Liabilities include everything that could potentially reduce a company’s assets. This could include debt, civil judgments, legal fines, pending lawsuits, and more. When you subtract all the liabilities from a company’s assets, you are left with a figure that represents the true value of a company. This is the company’s actual valuation. 

Once an auditor has all this information available, they calculate the total profits and true value of a company. In most cases, companies that have a low profit relative to their true value are less desirable. A lower ratio of profit to value may indicate that a company’s core product or service isn’t very successful. 

Valuations can also vary based on a wide variety of factors that are outside these four categories. For example, changing market conditions can also have a significant impact on a company’s valuation. If a company is selling a product or service that may not be desirable in the future, that can have a negative impact on a company’s overall value. 

Finally, it’s important to remember that a company’s value is often hard to forecast into the future. When investors choose to put their money into a company, they do so with the belief that the future value of the company will be higher than its current value. The path to increased value isn’t necessarily clear and can be subjective. However, auditors will use all the tools they have available to them to best determine the value of a company. For the savvy investor who can successfully forecast a company’s value in the future, there are significant amounts of money to be made.