How are Businesses Valued – the Three Primary Methods Analyzed

So you have hired a valuation professional to put a price tag on your business.  Although you trust the valuation analyst, you may ask yourself how it is possible for anybody to put a dollar value on the blood, sweat, and tears that went in to starting and building your company?  With all the information and complexities of your business, where does the analyst even begin?  Business Valuation can sometimes be as much art as science, however, there are three primary methods that are generally used in the valuation world.  A brief overview of each method is included below, to give you an idea of how a valuation professional will begin to determine value.

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Asset Based Approach

An asset based approach is focused on a company’s balance sheet, and analyzes the assets and liabilities of the business.

Book Value Method

One method involves examining the company’s book value.  The value of the business is deemed to be the assets on the balance sheet less all liabilities.  This method has its shortcomings, as the balance sheet as stated under Generally Accepted Account Principles (GAAP) may not reflect true current value.  GAAP requires assets to be stated at historical cost minus accumulated depreciation and also does not allow for a number of internally created intangible assets, such as trademarks, patents, and goodwill, which can be highly valuable, to be included as assets on the balance sheet.

Adjusted Net Assets Method

The Adjusted Net Assets Method attempts to overcome some of the shortfalls of the book value method.  Under the Adjusted Net Assets Method, each asset and liability is adjusted to its fair market value and the internally developed intangible assets that were left out of the Book Value Method are included.  This can produce a balance sheet that is more in line with the current value of assets, based on the replacement or liquidation costs of those assets.

Income Approach

An asset based approach does not consider the current or future earnings of the company, as it strictly uses the balance sheet to determine value.  An income approach examines a company’s earnings to determine value.  Although earnings is often the term used, the income approach can be used with a number of different measures including operating cash flows, after-tax cash flow, EBITDA, or net income, among others.

Capitalization of Earnings

This method identifies prior year earnings/cash flows, and uses a capitalization rate to determine the value of the future benefits from those cash flows.  This approach is often used when a company has historical profitability that is expected to continue in the future.  In many instances, a weighted average of prior year earnings is used along with an appropriate rate of return in the calculation of value.  The driving principle in this method involves the idea that a company’s value is derived from the future benefits to owners, through the form of earnings/cash flows that are available to those owners.

Discounted Cash Flows

The Discounted Cash Flow method begins with projected earnings/cash flows in future years and discounts them to the present based on time value of money principles.  Earnings are generally projected for a number of years and then a terminal value is calculated based on the projected earnings that are expected persist in perpetuity.  This method makes sense for the valuation of company whose earnings are anticipated to be significantly different in the future when compared with past performance.

Market Approach

A market approach can be the simplest to conceptualize, although it is sometimes difficult in practice.  A market approach looks at comparable company data.  The issue that often arises is the magnitude of data available for companies/transactions that would be deemed comparable to the business being valued.  The main sources of data include public and private company transactions, and prior transactions of the company being valued.  The subject company is often value using a specific parameter, such as revenue or earnings, in the calculation.  The calculation can be as simple as the following: comparable Company X sold for 4 times its gross revenue, so the value of the subject company is 4 times its gross revenue.

For the valuation professional, all three approaches are often considered in arriving at business value.  There are many nuances and details involved in the use of each approach, and each number that factors into the ultimate calculation has the ability to significantly impact the overall result.