Whether you run a small business or a large-scale corporation, obtaining a valuation for your business can benefit you greatly. Business valuations are used for a variety of purposes including: tax planning and compliance, financial reporting, estate planning, transactional (including ESOP), restructuring, litigation; amongst others. A business valuation can help business owners plan for the future by examining the components that will drive growth, mitigate risk in the business model and expand profitability. Ultimately, this positions the business for more favorable tax treatment upon transition to a family member or a higher sale price upon an exit from the business.
Given that there are many reasons why a business valuation may be needed, it is important to understand the three traditional business valuation methods and why each method is used, or not used in a particular situation.
While valuation is generally considered to be both an art and a science, a qualified appraiser will base a valuation upon accepted financial and time-tested methodologies. Here we outline a description of each method used in determining a fair and objective valuation.
The income approach is the primary methodology when it comes to business valuation. Given that all businesses are in the business of generating cash flow, the income approach relies on a set of forward-looking financial projections to estimate the future cash flows of a business and then discount those cash flows to present value utilizing a discount rate that reflects the inherent risks of running a business where future outcomes are unknown. In the simplest terms, the income approach involves looking at the organization’s financial history to make projections about their future profits and cash flows.
There are two methods generally used for valuing a company using the income approach:
• The discounted cash flow (DCF) methodology arrives at a valuation by projecting the cash flows in the future and then discounting these cash flows back to the date of the valuation. The advantage of this approach is that the company can see what their annual cash flows are expected to be in the future.
• The capitalization of cash flow method arrives at a valuation by dividing the historical total cash flows of the business by its capitalization rate. As reference, a capitalization rate reflects the risk of a business and its expected growth in the future. This approach is sometimes preferred since it utilizes actual company financial results historically. On the other hand, the downside is this perspective assumes the future will be representative of the past performance.
The market-based approach views a business’s assets through a broader lens, comparing them to similar businesses and transactions in its industry. The theory behind the market approach is that the value of a business can be estimated by comparing the business to guideline companies for which transaction values are known. When preparing a market approach valuation, appraisers compare the representative financial levels (e.g., revenue, EBITDA, earnings) of a company in the same industry as the subject company being valued.
Difficulties arise under the market approach as it can be hard to find publicly available information given that a peer comparable company may be private and not required to disclose its financial information to the public. However, the big advantage of the market approach is that when comparable data is found, an appraiser can see exactly what a similar company is worth in the marketplace. These pricing multiples are then used to help estimate a reasonable selling price for the subject company when comparing the company to the market.
To avoid the difficulties that may exist with an income or market approach, many business owners may want to have their company valued using an asset approach. An asset approach valuation is essentially taking the fair value of the assets less the fair value of the liabilities of the company at the valuation date. While this approach is generally used to value a real estate or holding company, this approach should not be used for an operating business. Unless the business is asset intensive in nature, it is essential that an income or market approach should be performed to obtain the true value of an operating business.
Accurate and defendable valuations combine multiple valuation methods for a comprehensive assessment. In a perfect world, all of the methodologies used in the valuation analysis would result in similar values. Unfortunately, given the nature of business valuation, it is typical that each methodology will generate a unique value estimate that differs from each of the other methodologies. Sometimes the differences are minimal, but in many cases the contrast in value estimates can be quite significant. Triangulating several methods can be a highly intricate process, and a skillful and thoughtful appraiser will work to ensure that all three approaches are aligned.
A business valuation is much more than a multiple of revenue or EBITDA. A consistent and defendable business valuation considers many factors to derive a fair value conclusion. A valuation professional will carefully select the right method to arrive at a representative value of the business or business interest being examined.
Determining how best to value a business enterprise isn’t difficult if you turn to highly skilled and experienced appraisers. If you are interested in learning more about business valuations and if now is the right time to move forward with one, please reach out to us for a conversation today.
About the Author:
Managing Director, Objective Valuation, LLC
20+ Years of Experience
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