A Guide to Business Valuation Methods
Our partner appraisers offer business valuations to clients interested in determining the value of their business. While there are many methodologies and techniques used in the business valuation industry, they are typically categorized into three primary approaches: Asset-based, Income-based and Market Comparison-based. Depending on the appraiser and company need for the valuation, several methods may be used in combination (a blended model). Which method the appraiser uses is most frequently based on the appraiser’s judgment, assets in question, past and future cash flow capacities, as well as the depth and breadth of available financial, operational and industry relevant data. All methods used to perform the valuation will be presented within the valuation package.
Asset Based Approach
The asset, or cost, approach considers the value of a business to be equivalent to the sum of its parts or the replacement costs for the business. This is an objective view of a business. It can be effective in quantifying the fair market value of an entity’s tangible assets as it adjusts for the replacement costs of existing, potentially deteriorating, assets. The key values used in the asset-based approach are Book Value, Going Concern Value and Liquidation Value.
- The Book Value is calculated by subtracting the book value of a company’s liabilities from the book value of its assets. This method is most often used in buy/sell agreements but, in many ways, comes with serious flaws. Many privately held companies use GAAP accounting standards which are not intended to reflect current asset values or adjust the value of liabilities using rates.
- The Going Concern method derives value by determining what existing business assets are worth, minus any outstanding liabilities.
- The Liquidation method is based on the value of the company’s assets if it were to go out of business and assets were sold off in an auction or wholesale event where the Seller would be compelled or forced to sell. Be aware, this method does not effectively value intangible or goodwill asset values such as patents, trademarks or brand awareness. Appraisers with expertise in machinery and equipment along with other tangible asset values in the event of a forced liquidation are well-versed in using this method.
Income Based Approach
The income-based approach identifies the value of a business by measuring the current value of projected future cash flows generated by the business in question. It is derived by multiplying company cash flow by an appropriate discount rate. In contrast to the asset-based approaches, which are more objective, the income-based approach can require the valuator to make subjective decisions about discount rates or capitalization. Many considerations and variables are measured to account for the specific contributions of value drivers in a business that influence cash flow: revenue, expenses, capital investments, taxes, etc. The three primary income-based methods are the Discounted Cash Flow (DCF), Capitalization of Earnings and Earnings Excess methods.
- The Discounted Cash Flow (DCF) method is based on the concept that the company’s total value is based on its projected future earnings. This approach is often more suitable to investment opportunities. An appraiser will determine an appropriate discount rate that accounts for the time value of money and what returns can be expected in the future over a set period of time, such as 5-years. Accurate historical financials of the business in question are useful for this method to work so that future projections of revenue, operating costs, cost of capital and working capital can be accurately forecasted.
- The Capitalization of Earnings method determines value based on future estimated earnings and cash flow generated by a company, capitalized using an acceptable capitalization rate. This method assumes that all assets (tangible and intangible) are aggregated parts of the business and does not try to separate out their unique values. It is appropriate when valuing a profitable business where an investor or owner is seeking a return on investment over time based on total cash flow.
- The Excess Earnings method derives value based on the net income generated from a company’s intangible value. While useful in some scenarios, this method is risky due to the difficulty in establishing accurate values for key factors including the rate of return on normal income and normal tangible equity of the company and in estimating the capitalization rate for excess earnings. IRS Revenue Ruling 68-609 says this approach may be used only if there is not a better basis available and the IRS has since concluded that “to get two fairly accurate rates, one for tangibles and another for intangibles, other than by the use of pure guesswork, is impossible”.
Market Based Approach
The market-based approach to business valuation is based on current market conditions of recent buy-sell transactions, both public and private, and the terms of such transactions. A fair comparison is residential real estate and the importance of using comparable houses (“comps”) recently sold to derive costs per square foot. In market-based business valuations, this is a more ‘user friendly’ method as it’s easily understood and more readily accepted by all concerned. It is critical that the appraiser use reputable and current databases for public and private company transactions such as Bizcomps or Pratt’s Stats. The market approach is suitable when a business is for sale (setting an offer or asking price), defending value in a legal or tax dispute or working through partner buyout agreements.
When a client engages our partner appraisers to conduct a valuation, they will view the value of that business through a multiple approaches (all of which fall under the three primary methods) and then determine which are most applicable to that business and its type of operation, industry, history and future outlook.
Know your value, know your business.