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By by Hilary L.

How to calculate equity in a business

There are numerous ways to calculate the equity in a business. The method an investor uses depends on the type of business. With that in mind, here are the most common methods and where they are best used:

Method one – Assets vs. liabilities – Many companies have significant inventories of real products as well as amounts due and amounts payable. Valuing the equity in these companies is fairly straightforward. First, total all the current and long-term assets – these include things like real estate, equipment, inventory and accounts receivable – to arrive at the "total assets" number. Next, do the same for current and long-term liabilities – ensure that payroll due and accounts payable are included. Finally, subtract the latter from the former to arrive at an approximate value for the equity in the company.

Method two – Earnings multiples – A more sophisticated but still well-accepted method for valuing any business – but especially service ones – is to use their earnings as a basis for their equity value. Generally, this method determines a value by calculating the net present value of the future earnings of the business. It is a technical process that discounts future cash earnings and applies multipliers to the EBIDA (earnings before interest, depreciation and amortization) while trying to use all the techniques that stock analysts use to value public companies.

Method three – Free cash flow – Some companies – Amazon, eBay and Google are good examples – have never made a profit and yet they are immensely valuable when it comes to their equity. The secret is in the amount of cash flow they generate that allows subsidiaries to exist, thrive and generate their own profits. In addition, with a lot of free cash flow these companies are able to act like banks without the licensing and regulatory hassles by using the capital of their customers to attain their own financial ends. Do not be fooled. This valuation method is complicated, expensive and requires the expertise of CPA's, other financial analysts and usually lawyers.

Method four – The market approach – Probably the most subjective approach to valuing the equity in a business, this approach is the one most favored by small business owners. This method compares a business to others in the same industry, of the same size and within the same geographic area trying to consider such factors as comparables, market conditions and the size of the opportunity. The problem with this method is that most business sellers overvalue the company's worth while buyers are more likely to place a less than reasonable value on such nebulous – that is, hard to exactly quantify – factors as goodwill, customer base and potential growth.

A final thought – In many cases, valuing the equity in a business is more art than science. It requires the seller to substantiate the science aspect of the process while the buyer must also appreciate the art. Otherwise, it is very difficult to come an agreed upon value.

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