Business valuation methods

Business valuation methods

Business Valuation: is the process of determining the economic value of a business or company.

Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership and divorce proceedings. predominantly, owners will turn to professional business valuators for an objective estimate of the business value.

There are several methods that might be employed to determine business valuation depending on the specific nature of the company being valued.

  1. Asset approach.
  2. Market approach.
  3. Income approach.

Asset approach

The asset approach to business valuation considers the underlying business assets in order to estimate the value of the overall business enterprise. This approach relies upon the economic principle of substitution and seeks to estimate the costs of recreating a business of equal economic utility, i.e. a business that can produce the same returns for its owners as the subject business.
The business valuation methods under the Asset Approach include:

  • Asset accumulation method.
  • Capitalized excess earnings method. It works to determine the business value as the sum of the following:

  1. The fair market value of the business net tangible assets:
    The net tangible assets are determined as the difference between the total assets of the business and its current liabilities.
  2. Business goodwill:
    Is calculated by capitalizing the value of business “excess earnings”. Excess earnings are the difference between the business Net Cash Flow and a fair return on the net tangible assets. We use the discount rate as the proxy for this fair rate of return.

Market approach

The Market Approach involves valuation methods that use transactional data to help determine a company’s value. These methods might involve private company transactions, public company transactions, as well as public company valuation measures using current stock market data. The theory behind this approach is that valuation measures of similar companies that have been sold in arms-length transactions should represent a good proxy for the specific company being valued.

Additionally, the market approach can be used to determine the value of a business ownership interest, security or intangible asset. Regardless of what asset is being valued, the market approach studies recent sales of similar assets, making adjustments for differences in size, quantity or quality.

In the real estate industry, a property's value can be estimated by looking at the comparable: recently sold properties that are similar in size and features that are located within a close geographic proximity to the property being valued. Outlier transactions, indicative of particularly motivated buyers or sellers, may need to be compensated for since the price may not adequately reflect the fair market value.

Income approach

The Income Approach to business valuation uses the economic principle of expectation to determine the value of a business. To do so, one estimates the future returns the business owners can expect to receive from the subject business. These returns are then matched against the risk associated with receiving them fully and on time.

The methods under the Income Approach include:
1.Discounted cash flow method:
This income-based business valuation method provides highly accurate estimate of business value based on the business earning potential. Under this method, we determine the business value by discounting the future business earnings using the so-called discount rate which captures the business risk. The use of this method requires the following three inputs:
1. Business net cash flow forecast over a pre-determined future period
2. Discount rate
3. Long-term residual business value

Our Income Statement forecast provides the net cash flow numbers five years into the future. Since the subject business is debt-free, we use the equity discount rate calculated earlier. Finally, the residual business value which represents that portion of business value past the net cash flow projection period is calculated as follows:
CF5→ is the net cash flow estimated in year 5 of our forecast.
g →is the long-term growth rate in the net cash flow.
d →is the discount rate.
R →is the residual business value.

2.Multiple of Discretionary Earnings Method:
The Multiple of Discretionary Earnings method is a variant of the direct capitalization methods under the Income Approach. Essentially, this method establishes the business value as a multiple of its earnings adjusted for the net working capital, nonoperating assets, if any; and long-term liabilities.

3.Earnings Basis Calculation:
To determine the business value using this method, we use the Seller’s Discretionary Cash Flow (SDCF) as the basic measure of the business earning power. We estimate SDCF as a weighted average of historic values obtained during the company’s income statement reconstruction.

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