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; however, there are only a few accepted business valuation approaches. Often times, owners believe that there is a single way to value their business and are surprised to discover there are several methods through which a valuation is determined. Although choosing the most effective method is typically best left to professionals, business owners can 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 individuals seeking to sell their company, since it allows them to identify ways to enhance the long term value of the entity. Below, our Business Succession Planning consultants provide a summary of these various valuation methods. With help from our skilled advisors, your organization’s business valuation can be conducted thoroughly and accurately.
Three Approaches to Business Valuation
According to leading business valuation associations, there are three major approaches to business valuation:
- Income Approach – This approach 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 valuations, reflecting the costs, inflation, and risks associated with ownership of the business 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 simple for investors comparing different businesses in various industries or locations. However, 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 familiar process many people have experience in. A business valuation professional might evaluate private company transactions and other similar companies that have recently sold. By evaluating these 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 only 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.
A fair and objective valuation is necessary for business owners, in order to have the best idea of what their company is worth today, whether for planning or other purposes. Depending on the valuation method applied, there are many variables that should 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. Company owners looking for assistance with business valuations can reach out to the Business Succession Planning representatives at Sikich for advice on different methods or approaches.