Understanding the basic business valuation methods
Many business owners understand the broad concept of a business valuation, but even financially savvy owners often do not understand the underlying concepts. While most business owners are busy day-to-day working, especially in system integration or engineering technology, it is critical for them to take time to also work on their businesses. Although the business is most likely the most valuable asset, few owners have an accurate idea of the business’s value. Not knowing the business value and the factors that are considered for a proper valuation presents limitations, such as the ability to increase value and to accurately plan for the business’s future.
The problem with not knowing the value of a business, is that it creates issues making critical business decisions. Situations such as the sudden illness or death of one partner, divorce, being approached unexpectedly by an interested buyer, and even everyday things such as how much insurance is needed are all critical situations that call for an informed answer that can be guided by having an up-to-date valuation (not to mention an up-to-date buy-sell agreement, which will be covered later in this series).
Knowing the basic methods experts use to value a company is important to be more informed when speaking to an expert.
So how do experts value a business? Business valuations go beyond a multiple of revenues or earnings. Experienced business appraisers apply several approaches and methodologies based on the specific business being valued. The key is to understand all business components, not just the financial statements. A valuation is about the story behind the numbers.
The asset approach derives a value by adjusting the company’s assets and liabilities from the reported book value (valued at original cost) to the estimated current fair market value. This approach reflects an orderly liquidation and does not consider the business’s future earning capacity. This approach assumes the business is worth more in liquidation than as a going concern, which is rarely the case.
This method is appropriate for holding companies, such as companies owning real estate, capital-intensive companies, or companies that do not possess good-will value.
The market approach is based on the concept of substitution. Transactions from publicly- traded companies, closely held comparable companies, and prior arms-length transactions of the subject company’s equity provides the appraiser with earnings multiples to apply to the subject company to arrive at an indication of value. This method is frequently used as a "reasonableness test" to the income approach.
The income approach projects future earnings streams and discounts these streams to their present value using a cost of capital reflective of a typical investor’s required rate of return. There are two methods used under the income approach—capitalization of historical earnings method and the discounted cash flow method.
The capitalization of historical earnings method requires that an estimate be made for a normalized cash flow, which is adjusted for revenue or expenses that are out of the ordinary or not at market levels, and divide into that figure a capitalization rate to estimate the value of the business. This method only should be used when the company’s future is expected to look very similar to the recent past’s financial performance. This method applies to very few closely held businesses, as most are too dynamic (growing, shrinking, changing) to assume one earnings figure is reflective of the future of the business’s financial performance.
The discounted cash flow method develops multi-year detailed projections of the company’s revenues, expenses, and cash flows that are discounted at a cost of capital that accounts for the risks and opportunities inherent in the business. The present value of the cash flows is then calculated, plus a residual value, to arrive at an estimate of the business value. Discounts for the lack of marketability and premiums for control are then determined and applied.
All three of these approaches should be considered when determining a meaningful conclusion of value, although not all are weighted equally in the final conclusion. It is important that these valuation approaches consider all of the factors that would increase or decrease the value of the business, not just the financial results of the company.
Even with this information, an experienced valuation expert can help educate those who are starting the valuation process. If someone can’t or won’t explain these topics and instead wants to focus on using a multiple of some number from your financial statements, it should raise a red flag. There is more to a business’s current and future value than a few financial numbers can exemplify. An appraiser who is accredited through the American Society of Appraisers (ASA), for example, is educated and committed to following the proper practices when conducting business valuations.
Catherine J. Durham is accredited senior analyst, principal, and president, Capital Valuation Group; edited by Emily Guenther, associate content manager, Control Engineering, CFE Media, firstname.lastname@example.org.
- The concept of a business valuation
- The basic methods that are used to value a company
- What approach to use for business valuations.
How often should a business owner request an updated valuation report?
Coming soon: A link to part 6 in the Business Valuation Article Series will be offered below.