There are many reasons why a business owner would want to be able to determine the value of their business. This is achieved through a process called business valuation. The individual procedures and prescribed processes that go into a business valuation are complex, but the following information can help you gain a general idea of what it involves.
When valuing a business, there are three commonly accepted approached. The three main approaches are the Asset Approach, the Market Approach, and the Income Approach. Each approach has its own set of procedures, rules, and methodologies, but generally, they all collect certain data and compare your data to other transactions, buyers, or investor expectations to determine what you Company may be worth.
Perhaps the easiest to understand is the Asset Approach. The asset approach derives a business’s overall value by first determining the value of all the assets it owns, and second, subtracting the liabilities to which it is bound. The current fair market values for each of the business’s assets and liabilities are estimated and compared in the aggregate. The excess value of the assets over the liabilities is the estimated value of the business. While easy enough to understand, the application may get complicated if the business has hard to value assets such as goodwill, intellectual property, or other intangible assets and debts which are hard to quantify. This approach is most commonly used in the valuation of businesses which have easy to value assets such as real estate, minerals, and marketable securities. Sometimes this is the best approach to determine value for companies which are struggling and returns that are less than ideal.
Next up is the Market Approach. it involves comparing your business to similar companies which have sold to determine what yours might bring if offered for sale. Much like a real estate appraisal, the key to utilizing this approach is to identify enough similar transactions and to adjust the results of those transactions to compensate for differences between the two companies. When the right data exists and is available, this approach can produce highly reliable results, but often data is limited and comparisons are difficult for small unique companies.
Finally, the income approach bases a business’s current value on its prospects for providing economic benefits in the future. In general, buyers are willing to pay only for anticipated future – not historic – cash flows. In applying an income approach, the development of reliable forecasts of future cash flows to the owner and the identification of investor required rates of return are critical. Expected rates of return are derived from an examination of alternate, risk adjusted returns available in other investment opportunities. Substituting one investment, (like your Company’s ownership) for another investment helps quantify what this rate of return should be. Once future cash flows are determined, the application of an appropriate discount rate will derive a present value of those future cash flows. When the correct inputs are utilized, the results are very accurate. Generally, this approach is best suited for operating companies engaged in an active trade or business.
Having several different approaches allows from the valuation of a wide array of business types which generate value for the owners by different means. Often, they provide multiple perspectives on the same business and it is not uncommon to use more than one approach in reaching a conclusion of value. In the appropriate combination, these approaches provide the framework to develop well-reasoned and informed decisions on the value of any enterprise.