How Do I Value My Business?
How Do I Value My Business? Within industry-accepted frameworks, there are three main valuation approaches, with each approach having various valuation methodologies within it. We’ll keep this article simple, while giving you the insight into how you can view your business in relation to the valuation process.
For the most complete and robust valuation process, all three approaches must be executed. However, depending on the specific factors of the business, one or more methodologies will be better suited or applicable.
The Asset Approach
You may have heard this: “Take all the business’ assets and minus all the business’ liabilities.” Basically, this statement refers to what you see in the equity section on your balance sheet. But this is not accurate.
Asset-based valuation, in simple terms, is finding the current economic value of all assets, minus the current economic value of all liabilities. In other words, the current economic value of each asset and liability may not be what is currently stated on the balance sheet. An example is a motor vehicle that has been depreciated beyond its current market value (taking advantage of the depreciation thresholds for tax purposes).
As previously mentioned, the specific approaches can be more or less applicable depending on the case facts. If the subject business is going to be liquidated, then often the asset-based valuation is the preferred methodology, as there is no future income or profits to consider. Liquidation again will have an impact on the current economic value of the assets, as they will most likely be discounted to sell fast, as with a fire sale, for example. When the business is profitable or has reasonable growth prospects, this value is often not captured on the balance sheet and, therefore, not captured under the asset-based approach.
For many companies, intangible assets make up a sizable portion of the balance sheet, and can be very difficult for laypeople to calculate on their own. Software, data, and similar companies rich in intangibles often call in valuation experts for assistance.
Market approach means comparing other companies that are similar enough to the one being valued.
The easiest way to think of this in perhaps the most common market is in terms of property and housing. The asset’s value is largely determined by the price at which similar assets in the local area most recently sold for (the similar three-bedroom, two-bathroom house on the same-sized block on your street that sold for X amount last month, for example).
For privately held businesses, valuation appraisers will use a few different methods at their disposal and, again, apply the most applicable depending on the available data and case facts:
- If the business has gone through a recent round of funding (offering of equity/shares in the company to an unrelated third-party investor), this would demonstrate a recent transaction of a similar or exact-same company
- Private company transactions – finding recent transactions from various databases of private company transactions that are similar enough to the subject company.
- Public company transaction – finding recent transactions from various databases of public company transactions that are similar enough to the subject company
(For point 3 above, this value information is readily available due to regulatory requirements, and helps lift the veil that often makes large-scale private company valuation difficult.)
Earnings or Income Approach
Finally, valuation with income is a way to account for future cash inflows. Identifying how much earnings (profits) the company will generate into the future and valuing those future profits as of today (meaning the present value). This is most often seen when considering an investment, as the assets themselves aren’t of concern—only their ability to generate excess returns.
In this approach, there are two main methodologies:
- The discounted economic income (discounted cash flow), in which the future earnings are projected along a time horizon of often 3-5 years. This is done to capture the expected changes in cash flows to the historical ones (growth, decline, or both). This is then combined with other variables and added to a terminal value, which measures a continued steady-state growth into perpetuity, and discounted to the present day. This discounted process uses a Cost of Capital method. A primary downside to this method is that it’s as much art as science, and it’s subject to many variabilities. Changing economic conditions, slower-than-expected growth, increased costs in an area, and other variables and predictions can increase model risk and skew a valuation.
- The capitalization is derived from the Cost of Capital method, which uses a single measure of sustainable cash flows identified from the historical financial performance of the business and projects it into the future. To arrive at the business’ value, this identified number is then capitalized based on its risk profile.
How Do I Value My Business? Each approach and method have its place and benefit, and it’s typically best to use a mix of the three for analytic purposes. This simple explanation will give you a different perspective when examining your business and setting its valuation goals. However, as you can imagine, the complexity of the methodologies and required detail dramatically expand depending on the valuation purpose, such as tax compliance or litigation in which the valuation needs to be extremely defensible.