Three Approaches to Valuing a Business

Most closely held business owners want to know the value of their investments, especially if they are going to sell or gift shares to family members or charities. Valuing a private business is a complex undertaking, however. The only sure way to appraise a business interest is to hire a valuation professional who understands the current marketplace and the relevant value drivers for your business.

Magnifying glass examining financial data

Valuators use three general approaches to appraise private businesses and business interests. Here is a brief summary of each approach:

Asset-Based (or Cost) Approach

Under this technique, value is calculated by subtracting the market values of the company's liabilities from the market values of its assets. The balance sheet serves as a starting point for this approach. But the book value of equity doesn't necessarily equate with the fair market value of equity. Some assets may be understated on the books (such as equipment subject to accelerated depreciation methods) or missing (such as internally-generated intangible assets). Off-balance sheet liabilities (such as pending litigation or environmental liabilities) also must be considered when adjusting the balance sheet to market values.

This approach is commonly used for asset-holding companies or other businesses that rely heavily on tangible assets. It may also serve as the "floor" for the value of an operating business, in case the other approaches indicate a value below its adjusted net worth.

Market Approach

When using the market approach to estimate business value, appraisers compare the subject company to similar businesses or business interests that have been sold. Here are two common methods that fall under the market approach:

  • Guideline Public Company Method. Here, the valuator identifies publicly traded companies that are similar to the subject company and develops pricing multiples (for example, price-to-earnings or price-to-revenues). Nearly 30,000 companies trade stock on public exchanges, creating a wealth of transaction data. Many closely-held companies are too small and specialized to compare to large, diversified public stocks, however.
  • Merger and Acquisition Method. This method examines sales of similar companies. These deals may involve privately held or publicly traded companies. There are a number of proprietary databases available to business valuators that provide the details of these transactions. As with the guideline public company method (above), the valuator computes pricing multiples (such as price-to-earnings) and applies them to the subject company's financial metrics to determine value.

When searching transaction databases for comparable companies, a valuator uses specific "selection criteria" to obtain a relevant sample of transactions. Examples of selection criteria include:

  1. Industry
  2. Size
  3. Methods of operations
  4. Markets and customers served
  5. Accounting methods
  6. Projected growth in sales and earnings

Income Approach

This technique is based on the assumption that the value of a business is equal to the sum of the current values of expected future benefits. In other words, value is based on the subject company's ability to generate income in the future. The two most common methods within this approach are:

  • Capitalization of Earnings Method. Here, the value of a business is based on a single estimate of what the future income of the business is likely to be. In turn, the single representative period is divided by a capitalization rate that's based on the company's required rate of return and its long-term sustainable growth rate. This method is better suited for companies with established, stable cash flows.
  • Discounted Cash Flow Method. Discounting is a multi-period method of valuation. As such, the value of a business equals the net present value of its expected future cash flows or income. The cash flow or income stream is discounted by the company's required rate of return. Under this method, cash flows are projected over a finite period and then they're assumed to stabilize. Once earnings are presumed to be stable, a "terminal value" is calculated, typically using the capitalization of earnings or merger and acquisition method.

What's the Preferred Valuation Technique?

Valuators consider all three of these approaches when valuing a private business. But they may use only one or two methods when valuing a specific company. No technique works best for all cases. There are many factors that go into determining the value of a business. A valuation expert is trained in the art and science of applying these approaches to value your business. Contact an expert today to understand what your business is currently worth.

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