Faced with the need to value your business? You’ll most certainly find that it requires more than printing out a fresh copy of your balance sheet.
Multiple business valuation approaches exist, as businesses come in a variety of forms and have to account for different circumstances and market forces. You may need to know the precise value of your organization for a number of reasons: death or divorce of a shareholder, merger or acquisition, desire to sell the entire business and bankruptcy or tax reporting. And that’s only a few.
Primary Business Valuation Methods
Due to the complexity of the process, and the chance of legal implications if done incorrectly, business valuation specialists are typically relied on to perform the analysis. These professionals have many valuation methods to choose from, but the options boil down to three main approaches:
- Income approach
- Asset approach
- Market approach
In a perfect world, each of these three approaches would arrive at the same value for a given business. However, the information a business valuation analyst has access to will largely influence which approach they take and may even require a combination of all the approaches.
The income approach is focused on the business’s future earning potential. What gives value within this approach is the ability of a business to provide a return on investment. Valuing a business based on how much the company is projected to make can have greater utility for decision makers than the other common methods.
There are two main tactics within the income approach:
Capitalization of Earnings
When historical revenue and expenses of a business are stable, an analyst will generally use the capitalization of earnings tactic. Here, a business valuation analyst looks at historical profits, removes anomalies and concludes on a reasonable annual cash flow expected to be generated by the business. This calculation is then projected into perpetuity at a reasonable and sustainable growth rate.
Discounted Cash Flow
When historical revenue and expenses of a business are volatile, the discounted cash flow tactic may be utilized. This may also be what’s used when a business is growing at an unsustainable rate or contracting. Here, relying on input from management, a business valuation analyst will project annual future revenue and expenses until the operations are expected to stabilize. Then, arriving at this calculation of expected future cash flows, they will be discounted back to present day value.
On the surface, the asset approach may seem to be the simplest. A business valuation professional starts with the company balance sheet. They subtract liabilities from assets to calculate the net “book value.” The problem with this approach? Assets are listed at the cost originally paid for them, not their current value. A valuation expert will research how much cash assets would be worth if placed on the market today, but this leaves room for subjective interpretation. Additionally, a balance sheet commonly omits valuable intangible assets, such as copyrights, contracts, customer lists, brand recognition and others. Appraising these intangible assets can be costly. Due to the costliness of valuing intangible assets and potential for outdated information on balance sheets, the asset approach is commonly used as an auxiliary with others, rather than on its own.
For some businesses, examining the purchase price of similar companies reveals an accurate valuation. Businesses that have many similar competitors either regionally or nationally may be good candidates for this approach. There are two main tactics within this approach:
Guideline Public Company
For businesses with publicly traded shares, this serves as a good starting point for determining value. This method multiples the current stock price by the number of outstanding shares to arrive at a total figure for overall share value. For example, if a business is sufficiently similar to a pool of public companies, an analyst will derive value from the public companies. The analyst will then apply the multiple to the subject business to determine a value indication.
When there isn’t a pool of comparable public companies available to compare, the guideline transaction tactic may be used. Here, the business valuation professional searches public databases of businesses that have been bought and sold. If the analyst identifies a pool of transactions deemed sufficiently similar, they will apply an average of the purchase prices, adjusted according to market variables, to the subject business.
Special Considerations for Intellectual Property
Not all company valuations come down to how many widgets a company can produce. Intellectual property (IP) in the form of trademarks, brands, patents, trade secrets, copyrights and databases can significantly bolster the value of a company. In fact, it frequently forms the backbone of a company’s profitability and competitiveness.
A business appraiser knowledgeable about IP can adapt valuation approaches to these intangible assets. Options for assessing them include looking at cost of development, income generation and market value.
Benefits of an Accurate Valuation
You will rely on the figure that an appraiser derives to make crucial decisions. A small business valuation may be vital for successive planning, financing or buying out a departing partner. Fair taxation or the long-term profitability of a merger will also depend on accurate valuation figures. As you consider who to hire for this important job, examine a valuation specialist’s experience with your industry and ask for explanations when each candidate makes recommendations about how to approach your valuation.