If you talk to a professional business appraiser, it won’t be long before you hear about the business valuation approaches and methods. These are the tools of the trade - and it is important to understand their relationship.

Business appraisers enjoy having an arsenal of tools at their disposal. This gives them the flexibility to appraise just about any type of business or professional practice. Much of the appraiser’s expertise is in the proper selection of the right tools for each assignment.

Being highly organized people, the business appraisers like ordering things. So here is the basic taxonomy of the business valuation tools.

Business valuation approaches

At the top of the pile are the three ways to measure the value of a business:

• Asset Approach
• Income Approach
• Market Approach

Each approach lets you adopt a different view of what a business is worth. As the name implies, the Asset Approach looks at the values of business assets in order to determine the value of the entire company.

The Income Approach lets you measure the value of a business based on its ability to generate earnings at an acceptable level of risk.

Finally, the Market Approach offers you the way to estimate the market value of your business - by comparison to similar businesses that have recently sold.

Business valuation methods

When it comes to the actual calculation of business value, the business appraiser reaches to an array of techniques known as methods. Each major approach has a number of methods under it. The methods are the actual computational procedures you can use to calculate the monetary value of your business.

Here are the major business valuation methods grouped around their approach:

Asset-based business valuation methods

• Asset accumulation method
• Capitalized excess earnings or the Treasury Method

Income-based business valuation methods

• Discounted cash flow method
• Capitalization of earnings method
• Multiple of discretionary earnings method

Market-based business valuation method

• Comparative transactions method
• Guideline publicly traded company method

Best practice: multi-method business valuation

The methods differ in the fundamental approach and the details of the calculations. Since no method is better than the others, well-prepared business appraisals use a number of methods to round out their conclusion. Using a set of methods under each Approach is the best way to “cover all bases” - and get a highly accurate, defensible business apppraisal.

Multi-Method Business Valuation

If you need a recipe for an accurate, defensible business valuation make sure you choose a number of professionally accepted business valuation methods to do it.

Valuing a business requires that you carefully analyze the company across a number of economic fundamentals. Professional business appraisers approach business valuation in three ways:

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

Selecting and applying a number of proven valuation methods under each approach gives you a comprehensive view of the business value.

Using the asset-based methods such as the Asset Accumulation or Capitalized Excess Earnings, you can determine the company’s value based on the values of its assets.

The income valuation methods let you estimate the value of the company based on its earning capacity and risk. On the other hand, the market based appraisal methods focus on comparison of your business to similar firms that have sold recently.

All these methods take a different view of what drives business value. No one method is better than the other. That is why selecting a number of valuation methods is the best way to create a sound business valuation.

Given all the method choices, which ones should you pick? This depends on your specific business situation. Here are some suggestions:

Start-up valuation

Valuing a young company presents unique challenges. Since most comparable business sales involve established firms, it makes little sense to use the market-based valuation methods.

Asset based valuation methods focus on establishing the value of the business based on a proven, optimized asset base. Often, business goodwill is a large part of business value, especially for businesses in the service industry. Yet it takes time to build goodwill in a business.

A start-up’s value depends on its potential to generate future earnings at an acceptable risk. This leaves you with the income-based valuation method choices. One of the best ones is the Discounted Cash Flow method. You can calculate your business value based on a number of earnings forecasts, each with its own risk profile represented by the appropriate discount rate.

Business valuation of an established cash cow company

Established firms that tend to generate reliable, steady income streams are very desirable. As a result, they are frequent acquisition targets. This gives you plenty of business sale comparables data to make an accurate business market value assessment.

Direct capitalization methods, such as the Multiple of Discretionary Earnings method, are an excellent choice for valuing companies with stable, recurring earnings.

Steady earnings tend to be associated with a large, loyal customer base. The business becomes an institution in its market place which creates considerable goodwill. You can use the famous Treasury Method to calculate the value of business goodwill and total company value.

Valuing an owner-operator managed small business

If your business operates in the service, retail or wholesale industries, comparable business sales abound for small, successfull companies. Market based business valuation methods work very well in valuing such firms.

The Multiple of Discretionary Earnings method is a very common choice under the income approach. In addition to the business earnings, the method lets you determine the business value based on a number of financial, operational and lifestyle factors.

Professional practice valuation

Professional practices are a special type of service firms. Perhaps the biggest difference is that they tend to create considerable business goodwill. If you need to appraise a medical or dental practice or an accounting firm, the Capitalized Excess Earnings method should be high on your list.

For larger practices the Discounted Cash Flow method is the typical choice. On the other hand, you can value a single practitioner firm using the Multiple of Discretionary Earnings method.

If you are considering buying a small business or offering yours up for sale, the central questions are:

• What can the business sell for?
• How should I structure the price and terms of the deal?

Valuing a business to estimate its selling price

Not surprisingly, the business selling price is related to its value. Measuring the value of the business is what business valuation is about. One of the key reasons for a business valuation is to determine the market value of the business.

Company valuation using comparable business sales

Since your goal is to estimate the likely business selling price, an excellent choice of a business valuation method is to study the comparable sales of similar businesses. The actual business selling prices can be related to a number of business’ financial performance factors.

Business valuation multiples

This gives you the so-called valuation multiples. The multiples help you establish the business market value in relation to its revenues, profits, cash flow, assets or owners’ equity.

Valuing a Business using Valuation Multiples

You can apply these valuation multiples to calculate what your business is worth. For example, you can take the Price to Gross Revenues valuation multiple and multiply it by your business’ gross revenues. The result is the estimate of what your business is worth - and its potential selling price.

So far, so good. If you have enough business sale comparables, you can develop a good idea of the fair market value of your business. However, every business is unique. So it is possible that your business is worth more or less than the average.

How to evaluate a business based on its earning power

Enter the income-based business valuation methods. Instead of comparing your company to others, you can determine the business value directly based on its earning capacity and risk profile.

The classical methods to do income-based valuation are the Multiple of Discretionary Earnings and Discounted Cash Flow. Both focus on your specific business and give you the business value result that is as unique as your business itself.

Valuation of a Business - Multiple of Earnings

Business goodwill valuation

If your business has been around for a while, chances are it has developed considerable business goodwill. You can calculate this important part of your business value by using the Capitalized Excess Earnings valuation method. Known as the Treasury Method, this well-known appraisal technique helps you determine the value of business goodwill and total business value.

Putting the business sale together: price and terms

Now that you know what the business value is, the next objective is to put together the terms of the business acquisition that make sense to you. Business selling price is but one element of a successful business purchase. In fact, the business sale terms often make or break the deal.

From the buyer’s perspective, the deal terms must ensure:

• Down payment amount acceptable to the buyer.
• Generous financing terms for the balance of the purchase price.
• A living wage for the new business owners.
• Sufficient debt service coverage.
• Cash required for capital investments to keep the business running. This includes equipment purchases and working capital.
• Return on and of the buyer’s down payment, called payback.

Business cash flow must be sufficient to cover all these requirements - or the deal cannot be made. Depending on the buyer’s specific needs, the deal terms can lead to the offer price that may be well below the business value!

A strategic choice for business buyers and sellers

If you are selling your business, picking the right buyer is often the most strategic choice you can make. If you are buying a business, choosing your target carefully is well worth your while.

Structuring Your Business Sale or Purchase

You will hear this bit of wisdom from business appraisers and brokers: small business financial statements need to be adjusted before they can be used in a business valuation. More mistakes are made in business appraisals due to incorrect earnings choices than for any other reason. 

Most small businesses are managed to reduce taxes. Not surprisingly, accounting measures of profitability such as net income are generally unsuitable for business valuation. If you need an accurate business appraisal, focus on the cash flow based earnings instead.

Business earnings basis in small business appraisals

For small businesses that are managed by their owners the Seller’s Discretionary Cash Flow (SDCF) is the typical earnings basis to use. Here is the standard definition of SDCF, accepted by the International Business Brokers Association:

• Business pre-tax earnings
• Plus total compensation for a single owner.
• Compensation of other working owners adjusted for market rates.
• Plus non-operating and discretionary expenses.
• Plus interest and depreciation expenses.
• Plus one-time or unusual expenses.

The rationale behind the way the owners’ compensation is handled is this:

Assuming the business is to be sold, all current owners are expected to depart. The buyer is likely to be replacing the principal owner and thus will take over that owner’s compensation package. In addition, the buyer will need to hire management replacement to handle the duties of the other working owners.

The questions are:

• What tasks do the current owners perform in the business? 
• What is the current owners compensation?
• How does it compare to the typical salaries for non-owner managers handling the same tasks in similar businesses?

Needless to say, the way these questions are answered can have a considerable effect on the business cash flow going forward. Some typical situations the buyer is likely to face:

• Current business owners are underpaid for the work they do. This will require that the business come up with additional funds to replace the owners. The effect is to reduce the available cash flow, and the SDCF basis used in business appraisal.
• Current business owners are overpaid relative to their contribution to the business. The excess cash flows to the new business owner after the replacement managers salaries have been paid.
• Current business owners do not contribute substantially to the ongoing operations. Their entire compensation is thus discretionary.

Effect of owners compensation on business valuation

The additional cash outlay for key management functions reduces the business discretionary cash flow. This, in turn, will lead to lower business valuation results.

On the other hand, excess owner compensation is discretionary. This increases the business SDCF basis. The result can be a higher business valuation. 

You need to have a solid understanding of what the current business owners do, who will be leaving the business, and how their compensation compares to the market rates should they need to be replaced.

Even if you do not plan to sell the business, consider the effect on future business earnings of a departing co-owner who possesses critical skills. Are these skills readily available on the market at a reasonable replacement cost? The way you answer this question can make a big difference to what the business is worth.

Ask any professional business appraiser and you will hear the same advice:

If you need a business valuation that is both accurate and defensible, use a number of business valuation methods in your analysis.

There is a good reason for this insistence - no business valuation method is best. Each method looks at a different set of business fundamentals. This gives you a different view of what drives your business value.

If you are after a solid business appraisal that passes muster - in the boardroom or the court room - consider using several business valuation methods.

Asset business valuation tends to set the upper bound on your business value

Asset based methods, such as Asset Accumulation or Capitalized Excess Earnings, let you calculate your business worth based on its assets and liabilities.

The results tend to be on the high side, especially for asset-rich businesses such as manufacturing and distribution firms. A couple of reasons for this: some company assets may be currently underutilized. Business owners could rent out excess capacity or floor space and generate additional revenues.

Other business assets may not be currently put to their “highest and best use”. For example, business owners can license some of their technology and generate royalty income in addition to the current product sales.

Doing your business value analysis using asset based methods can help you uncover such value enhancing opportunities in your company.

Need to determine business fair market value? Consider market based appraisal methods.

Market is widely considered the ultimate arbiter of what a business is worth. Recent business sales of similar companies are an excellent way to determine the market value of your business.

In a stable market, business sellers and buyers enjoy roughly equal bargaining power. So the business selling prices tend to settle to an equilibrium - establishing the fair market value for your business.

Valuation multiples derived from such business sale statistics are a great way to come up with the most probable business value number - the reasonable selling price somewhere in the middle of the low and high range of selling prices.

A word of caution - business market value and its theoretical “fair market value” are not the same. Business market value is the expected selling price if you try selling a business under the current market conditions. Fair market value assumes that business buyers and sellers do not enjoy significant advantages over each other and that the market conditions are stable.

For example, in stressed markets some business owners may decide against selling. Others may feel compelled to sell just to get out. Such motivated sellers are unlikely to get a fair market value price for their business. If you observe the business selling prices in this type of market, you are likely to see valuation multiples that are well below their historic averages.

Your business valuation depends on your assumptions - income business valuation

No two businesses are the same, and each business person sees the value of a given business differently. Income based business valuation methods give you the tools to determine what the business is worth to you - based on your unique expectation of business earning prospects and risk.

Business appraisers often refer to the so-called investment standard of value when talking about income business valuations. What this means is that each business person uses a different measuring stick when estimating what a business is worth.

All business valuations are forward looking. Your income forecast may be different from mine. In addition, you may assess the company’s risk based on your specific action plan.

Even if we use the same valuation methods, the results may differ. Business for sale market has a couple of well-known participants that demonstrate two extremes:

The financial business buyers are after immediate, low risk income streams. They tend to be conservative in their earnings and risk assessment. Hence, their income-based business valuations trend lower.

On the other hand, synergistic business acquirors look for unique advantages. They can envision much more positive outcomes and calculate a higher business valuation result.

Business Valuation based on Assets, Income, Market Comps

If you are thinking of selling your business or plan to buy one, the central issue is how to determine the business sale price.

Setting the selling price of a business right is very important to a successful business acquisition. More deals go wrong because business buyers and sellers fail to agree on how to price the business.

In the current economic climate pricing a business for sale is more challenging than ever. You need to complete two important tasks to get it right:

1. Conduct a business valuation.
2. Structure the price and terms of the business sale.

Business valuation is the first essential step toward figuring out how much your business can sell for. Since the intent is a business sale, market-based business valuation methods should be your first choice.

Business valuation using private business sales comps

The most compelling way to determine the value of a business for sale is to compare the selling prices of similar private businesses that have sold recently. You can estimate your business market value using the valuation multiples derived from such transactions.

The typical valuation multiples help you estimate your potential business selling price based on the company’s gross revenues, net sales, net profit, EBITDA, cash flow or asset base. Using the business sale statistics, you can calculate your likely business sale price as a single number or a range of values.

Income business valuation - customized to your specific situation

Such market based business value analysis is an excellent way to determine the business fair market value. However, each business sale transaction is unique. The objectives and risk perceptions of the business buyer or owner may differ considerably.

That’s where the income-based business appraisal comes in. This approach to valuing a business for sale lets you account for your specific goals. To use the formal business appraisal terms, income-based business valuation may adopt the investment value standard. The result may be a business value that is either below or above the fair market value.

Strategic buyers can pay a premium price for the right business

The typical situation involves a synergistic business buyer. Such a buyer may be looking to realize some unique benefits through business acquisition. Often, the analysis of business value will show the number that is considerably higher than the fair market value estimate obtained from business sales comps.

The result of an income based business valuation depends on the forecast of business earnings and its risk. A strategic buyer may have plans for your business that indicate considerable earnings growth upside over the long term. In addition, the buyer may have a well-planned ownership transition strategy that minimizes the business risk. The result is higher business value.

Financial business buyers look for low cost income streams

At the other extreme are financial buyers who are interested in acquiring the business income stream at the lowest price possible. Expect conservative business valuations and low business purchase price offers from this group.

Find the right buyer to maximize your business selling price

Savvy business owners can make the search for synergistic business buyers an important part of their strategy to maximize the business sale price.

Valuing a business based on its assets

You should also consider using asset based business valuation methods. The key advantages offered by this approach is calculation of business goodwill and purchase price allocation among the business assets in a tax advantaged way.

Putting the deal together - business sale price and terms

Once you know what the business is worth, it is time to structure the terms of the business acquisition that make sense to both the buyer and the seller.

In addition to the business selling price, your deal structure needs to account for these important elements:

• The amount of buyer down payment.
• Terms of seller and lender financing, including the principal amounts, maturity and interest charged.
• Any amount of the business sale price to be held back in an earnout.
• Payback period required by the buyer to recover the down payment.
• Acceptable living wage for the new business owners.
• Amount of capital expenses required to run the business after the sale closes.
• Working capital injection if the business sale is structured as an asset transaction.
• Business acquisition expenses such as professional fees, closing costs, licenses and permits, and due diligence expenses.

Your business value and sale price may differ!

There could be a considerable difference between the appraised value of the business and its actual selling price. The reason is that the deal terms are unique to each transaction. As the terms vary, so does the amount of cash flow required to make your business acquisition work financially.

It is not unusual for a business to sell at a considerable discount if the seller insists on an all-cash transaction. Offering seller financing to a qualified buyer tends to increase the selling price while reducing the capital gains taxes for the seller.

If you are valuing a business based on its income, a major part of the challenge is coming up with accurate discount and capitalization rates. These factors capture the company’s risk - and affect the accuracy of your business appraisal.

You can determine the discount rate appropriate for your business by using the well-known Build-Up Model.

Market and company-specific risk

While some elements, or risk premia, can be determined by observing the overall capital markets, you also need to assess your particular business risk profile. This additional element gives you the important component of the discount rate - the company-specific risk premium.

Ten-factor company specific risk assessment

ValuAdder business valuation software gives you a consistent way to evaluate your company specific risk. You can do so by assessing ten important risk factors:

1. Business revenue growth prospects.
2. Company’s financial risk. Debt-free firms have much lower risk of financial failure than heavily leveraged businesses.
3. Operational risks. Consider the difficulty and costs associated with growing your business.
4. Business profitability compared to its industry peers.
5. Customer concentration. A business with many customers is less risky than a company that relies on a few large customers for most of its income.
6. Product concentration. A rich, diverse product mix reduces business risk - and contributes to higher business value.
7. Market concentration. Compare a business that sells into many different markets to a company whose market is limited.
8. Competitive position. A company in a well-protected market niche is less risky than a firm exposed to large, well-funded competitors.
9. Quality of management team. Experienced business managers tend to make good decisions that reduce risk and contribute to higher business valuation.
10. Quality of staff. Long-term employees are a great business asset. Their skill and dedication are major value-creating factors in any company.

One of the easiest and most defensible ways to approach valuation of a private company is to compare against the recent sales of similar businesses.

If the companies that have actually sold resemble your business closely, you can come up with a number of business market value estimates based on the so-called valuation multiples.

These multiples are ratios that relate the company’s financial performance to its potential selling price and, therefore, its fair market value.

One valuation multiple that is used often is the business price to its gross revenues. Others include value measures based on the company’s net profits, gross margin, EBITDA, cash flow, assets, and value of business owners equity.

Given the wide choice of valuation multiples, when does the price to gross revenues ratio work best to value a private company? Here are the typical situations:

High growth company valuation

A company that is focused on revenue growth may not yet be optimized for profitability. Hence, its value lies in its ability to generate sales. Valuing such a company on its gross revenues is a good choice.

Technology based company valuation

A special case of high growth businesses, the technology companies invest heavily in intellectual property development and marketing. It is not unusual to see negative returns for quite some time - even for companies with a commanding market share.

If you want to develop an estimate of market value for a technology company using business sales comparables, the gross revenue tends to be a more accurate basis than current profits or cash flows.

Professional practice valuation

Medical and dental practice valuations often rely on the practice sales as the preferred basis. One reason is that established practices tend to show similar profitability given the level of revenues.

Another key reason is that the value of a professional practice is most directly related to its ability to attract and retain clients. Gross revenues from client billings thus offer an excellent basis for estimating what a practice is worth.

Valuation multiples change over time - some surprises

We study the private business sales data all the time and run into quite a few surprises when selecting the best valuation multiples for our clients.

As market conditions change in an industry, business people tend to change their attitude to what drives business value.

A large group of business investors known as financial buyers tend to value companies based on their profitability. They are less likely to be impressed by business revenues, unless their expectations of returns and risk are satisfied. Financial buyers tend to use valuation multiples that are based on business cash flow, EBIT, EBITDA, and net income rather than revenues.

One example is the food and drink industry. Our analysis of restaurant sales in 2008 shows that business buyers have relied on the price to discretionary cash flow valuation multiples when pricing acquisition deals.

This is a shift from a year ago when most deals were priced using the gross revenue based valuation multiples.

To get an accurate business valuation you should not limit yourself to using just a single valuation multiple. In fact, you can appraise any business three ways:

• Based on the business income generating capacity.
• Based on the company’s asset base.
• By comparison to sales of similar firms.

Look at a professionally prepared business appraisal report and you will see that several methods are used to calculate what the business is worth.

See How to Value a Business Three Ways

Wondering how the current economic situation affects business valuation? To gain an insight, let’s take a look at the fundamentals of business appraisal.

Three approaches to business valuation

The value of any business can be measured three ways, known as approaches:

1. Market - by comparing the recent sales of similar businesses.
2. Asset - by studying the costs associated with business creation.
3. Income- by assessing the business earning capacity and risk.

Income-based business valuation - capturing the economic downturn effects

The income approach to valuing a business offers perhaps the best way to assess the effects of the economic ups and downs. The reason is this: all income-based business valuation methods are forward-looking.

Business value is affected by the earnings outlook

In other words, you can calculate your business value based on the business earnings forecast. Needless to say, the earnings outlook will be greatly influenced by macroeconomic factors.

Business valuation and increased risks

In tough economic times, business investment carries additional risk. Your income business valuation incorporates this in the form of discount and capitalization rates. The more uncertain the future, the higher the business risk and the associated discount and cap rates.

The build-up model for calculating the discount rate shows this effect very clearly. In particular, the risk-free return and equity risk premium reflect the macroeconomic environment - something every business is exposed to.

Your company’s risk also needs to be adjusted for the industry-wide factors. These affect all businesses operating in your industry. If the industry is vulnerable as a whole, the business is likely to be impacted as well. This increases the discount rate, lowering your business valuation.

To summarize, an economic downturn is likely to affect your business valuation two ways:

1. By lowering the expectation of business earnings.
2. By more conservative business risk assessment - which leads to higher discount and cap rates.

Example - how economic downturn can reduce business value

We will use the well-known Discounted Cash Flow business valuation method. As is the case with most professional business appraisals, we use the business net cash flow as the earnings basis. The result is calculated as the Market Value of Invested Capital, the typical value measure in small business appraisals.

Our initial earnings forecast, created before the downturn took hold is as follows:

• First year (2009):  $250,000.
• Second year: $275,000.
• Third year: $290,000.
• Forth year: $310,000.
• Fifth year: $335,000.

The company is debt free and we have estimated the equity discount rate to be 25%.

Given the latest developments in the market, we have revised our cash flow projections as follows:

• Year 1: $200,000.
• Year 2: $210,000.
• Year 3: $245,000.
• Year 4: $290,000.
• Year 5: $330,000.

We further conclude that the additional risks have increased the discount rate to 32%.

Using the Discounted Cash Flow method for both scenarios, gives us the following business valuation results:

1. Original figures: $1,440,231.
2. Revised for ecomonic downturn: $1,060,266.

In other words, the lower expectations of financial performance in the current market have reduced the value of the business by almost $400,000 or 40%!

Business valuations can increase in some market niches!

This, of course, is merely an example. A business can thrive in a down ecomony because it occupies a unique niche in its market.

Businesses and consumers looking to save money may keep their old cars running longer. While the new car dealership may suffer, the auto repair shop may get additional business.

For these companies, the earnings outlook and risk assessment may well paint a very different picture of what each business is worth currently.

Business Valuation based on Income and Risk

One way to value a business is by comparison to recent sales of similar businesses. The typical way to estimate your business value using such market comps is with valuation multiples.

A wide range of valuation multiples to choose from

These multiples are ratios that help you determine your business market value in relation to the company’s financial performance. For example, you can estimate your business worth based on its revenues, earnings, cash flow, EBIT, EBITDA, equity or asset values.

Which valuation multiples are more accurate?

Given the choice of valuation multiples, you may wonder: are some multiples more accurate for estimating your business worth?

Yes indeed! Since the valuation multiples are statistically derived, you can easily assess the accuracy of each - and choose the best.

Range of business values and coefficient of variation

Professional business appraisers pay close attention to the so-called coefficient of variation. It is a ratio of the standard deviation to the average value of a given valuation multiple.

The reason this is important is this: the smaller the coefficient of variation, the closer the actual business selling price multiples cluster around the average.

If you use the valuation multiple with the low coefficient of variation, your business value estimate is likely to be more accurate since it falls into a narrow range.

Another way to look at this is that the business people in your industry tend to price business sale deals using such valuation multiples.

Example: picking a multiple to estimate the value of a restaurant

Let’s take a look at an example. We are looking to estimate the market value of a privately owned family restaurant. The restaurant grosses $1,500,000 in annual sales, thows off $250,000 of discretionary cash flow, has $100,000 of inventory and is located in the Los Angeles area.

The typical choices of valuation multiples for this business are:

• Business sale price to gross revenues.
• Business sale price to seller’s discretionary cash flow.

So which one is the best choice?

We study the sales of privately owned restaurants regularly. The recent numbers show that the coefficient of variation for the above two valuation multiples are:

• Gross revenue-based: 0.554.
• Discretionary cash flow-based: 0.509.

The average multiples will vary with a number of factors, including the restaurant size, location, and specific market niche. A reasonable approximation for our example business is around 0.3 times the gross revenues, and 1.7 times the cash flow, plus inventory.

Here are our estimates for the restaurant market value:

• Gross revenue based - around $550,000 (including the inventory).
• Discretionary cash flow based - around $525,000.

Since the coefficient of variation for the cash flow-based multiple is lower, you should first consider the second restaurant value estimate - in this case $525,000.