There are many reasons a business owner may want or need a business valuation – including negotiating a merger or business sale, considering new shareholders, estate planning, or marital dissolution – but there are only a few accepted business valuation approaches. Often times owners are convinced there is a single way to value their business, but are surprised to discover there are several methods through which a valuation is determined. Although choosing the most effective method is best left to professionals, business owners will benefit from having a high level understanding of the different methods and how they are used to arrive at a final value. This is especially useful for those seeking to sell their company as it will allow them to identify ways to enhance the long term value of the entity. To help clients, prospects and others, Sikich has provided summary details of the various methods below.
According to the leading business valuation associations, there are three major approaches to business valuation:
- Income Approach – This approach may serve a healthy business well as it focuses on current earnings and past financial indicators to predict future income. Future cash flow predictions – or earnings potential – are converted into a single present dollar amount for valuation reflecting the costs, inflation, and risks associated with ownership of the business or business interest for the time period used. Income may be represented as after-tax profits, pre-tax profits, EBIT (earnings before interest and taxes), EBITDA (EBIT plus depreciation and amortization), or using other cash flow measures. The two most commonly used methods under this approach are the Single Period Capitalization Method and the Multiple Period Capitalization Method, which are easier to apply for businesses with a more predictable growth rate. Using an Earnings Multiplier Method, where value is based on a multiple of the business’s earnings potential, can be more tangible and simpler for investors comparing different businesses in different industries or locations, but agreeing to the definition of “earnings” and variance in multipliers (whether 1, 3, 5, or even 10) can become a challenge.
- Market Approach – A market approach uses actual sales data to get comparable (or “comps”) that help determine a company’s value. This is very similar to how residential real estate is valued, which is a process most have experience in. A business valuation professional might evaluate private company transactions and other like-kind companies that have recently sold. By evaluating certain company against similar businesses in your industry, location and recent sale price, a valuation professional can gain an understanding of the business value in the existing market under current conditions.
- Cost Approach – This method is also known as an asset-based approach, where the value of the business is determined by the total market value of the company’s tangible and intangible assets and liabilities. Tangible assets, such as equipment and inventory, are much easier to value than intangible assets, such as a loyal customer base and brand awareness in the marketplace. Also, because this approach ignores any earnings potential and may be considered “over-simplified,” it often benefits certain companies more than others. For instance, if your plan is to liquidate the business or if earnings numbers are either not promising or typically volatile, this method may be used.
Unlike many other services an accounting firm offers a business valuation is not an exact science. Depending on the valuation method utilized there are many variables that need to be considered and assessed. For this reason, it’s essential to work with a valuation professional that has experience with your company type and industry. A fair and objective valuation is necessary for the business owner to have the best idea of what the company is worth today for planning and other purposes. Looking for assistance with a business valuation, then Sikich wants to help! For additional information please contact Ray Lampner, CPA, at 330-572-8014.