You can value any business or professional practice three ways, known to professionals as valuation approaches:

1. Market - by comparing your business to similar businesses that sold recently.
2. Income - by assessing your company’s earning power and risk.
3. Asset - using the business assets as your valuation basis.

Business Valuation Three Ways

There are a number of well-known business valuation methods under each of these approaches. It is a very good idea to use several such methods to determine what your business is worth.

So what methods should you pick for your business valuation? The answer depends on your specific situation and the assumptions you make. Truly, business value is in the eyes of the beholder.

Valuation of a business for sale - buyer and seller’s numbers may differ

Consider a typical situation when a business is put up for sale. Business owners, naturally, would be very interested in the highest possible business valuation numbers. On the other hand, a business buyer is likely to be far more conservative when valuing a business to buy.

Conservative business valuations in gift and estate tax situations

Business owners looking to minimize gift or estate taxes will look for the lowest possible business appraisal. The same owners are likely interested in a higher number when presenting their business to strategic investors. Needless to say, the tax man will probably be skeptical if your business appraisal is too low.

Partner buyouts - two views of what a business is worth

In a partner buy-out situation the remaining partners want the lowest possible value for the departing partner’s share of the business. On the other hand, that departing partner is interested in a higher valuation. This is one reason why buy-sell agreements are important.

Are all these different business people fudging numbers? Not necessarily! What they are doing is factoring in their specific assumptions into their business valuation. And these assumptions affect the results they get.

Different assumptions affect your business valuation conclusion

The main point is that your business valuation numbers can differ from someone else’s. This does not disprove your business appraisal - as long as you can demonstrate that your assumptions and business valuation method choices make sound sense.

Business valuation model = key assumptions + choice of methods

Enter the business valuation model - the set of assumptions you make and business valuation method choices for your business appraisal. Based on your specific situation, your business valuation model may differ from mine - yet both can produce defensible business valuation results.

A business seller and buyer may come up with a different opinion of what the business is worth. To close a successful business sale though, they will likely arrive at a compromise - a number acceptable to both parties.

If you convince your investors that your business is worth a certain amount, then your business valuation works. You have made the right assumptions at the outset and picked the business valuation methods that made sense to your investors.

The moral of all this? Your business valuation is right if it serves its intended purpose.

To make sure that it does, you need to spell out your assumptions and be able to show clearly why your choices of business valuation methods are the best.

Whether you are valuing a business by yourself or engage a professional business appraiser, a business appraisal report is a typical work product you get.

Such a report does more than summarize the business valuation results - it clearly defines what business ownership interests are being valued. Importantly, it also shows the key assumptions and judgement calls made by the business appraiser.

Now, as a busy business person you may be tempted just to glance at the business valuation result, decide if it is reasonable, then file the report.

Nothing wrong with that, but there is more to be gained from a well-prepared business appraisal report. If you plan to share your business appraisal with others, it is likely they will have questions about your conclusions. On occasion, they may even challenge your business valuation results.

The reasons any business appraisal can be questioned

Business appraisal deals with the business’s future economic prospects. This necessarily requires that you make a number of assumptions. And these assumptions mean that you, or the business valuation expert you hire, make educated judgement calls in order to reach the business value conclusion.

Needless to say, the reader of your business appraisal report may disagree with some of the assumptions contained in the report.

• Are the business sale comparables really comparative to your business? 
• How realistic is your projection of the future business income?
• Have all the elements been considered when assessing the company risk?
• Why were these business valuation methods, and not others, chosen to calculate business value?

Typical business appraisal accuracy

Even the most thorough business appraisal will depend for its accuracy on some “leaps of faith” that will affect the final business valuation outcome. So two equally skilled business appraisers will likely come up with different valuation results.

How different? It is not unusual to see a difference of around 20% - 25% between professionally done business appraisals of the same company. In fact, an increasingly common practice in business appraisals is to report the result as a range of business values.

Business appraisal results are useful - if you can defend your assumptions

So if you meet with a healthy dose of skepticism when sharing your business appraisal results with others, you will appreciate why your business appraisal report contains more than just a number.

To use your business appraisal results effectively, spend a bit of time to understand and be prepared to defend the assumptions that drive your business value conclusions.

What’s in a Business Appraisal Report?

Ask a professional business appraiser about how to value a business and
you will hear that there are three ways or approaches to measuring the business worth:

1. Market - based on comparison to similar business sales.
2. Asset - which looks at the values of business assets and liabilities.
3. Income - where you determine what a business is worth based on its income and risk.

The good thing is that you can value any business using these approaches, regardless of the company’s current financial performance.

Put differently, a business that is not profitable at the moment, may still have considerable economic value, and be worth quite a bit of money.

Business value depends on the long-term earnings outlook

Remember that all business valuations are forward looking - your business value is defined by the future business prospects. And there is a number of things business people can do that affect their business worth. For example:

Business owners may decide to merge businesses that lose money. The combined company may enjoy advantages that drive profitability: better product bundling, access to new markets, lower costs due to economies of scale from combined operations, and much more.

A business can attract smart investors that bring not just money but considerable managerial skills to the table. This may help the company develop new products and services, enter new markets, and turn its technology and know-how to profitable use.

Over time, the company owners may introduce operational changes that cut costs and improve efficiency. Long-term employees are often an excellent source of ideas - and how to implement them to contribute to the bottom line.

Putting the business up for sale

Of course, the company owners may decide to sell the business. Can an unprofitable business sell? Yes - provided the right type of business buyer is found. Some typical types:

Financial business buyers

Typically savvy investors that focus on low-cost income streams. They tend to look for low-debt, highly profitable companies.

Synergistic business buyers

These may be a group of investors or a larger company looking to grow through acquisitions. Such buyers may well be interested in the acquired company’s longer-term potential beyond its immediate profit numbers.

Business valuation models and methods for unprofitable businesses

Market comparisons to similar established companies are an excellent way to estimate what your business is worth. You have quite a choice of standard valuation multiples that relate the business potential selling price to its financial fundamentals.

Valuation multiple choices that work well

For an unprofitable company, the following valuation multiples are especially useful:

• Business selling price to gross revenues or net sales.
• Business selling price to business assets, such as total assets or tangible assets.
• Business selling price to book or market value of business equity.

If you plan to re-capitalize the business or sell it to a well-funded buyer, the valuation multiples based on business revenues or asset base are very useful. Selling price to total assets is especially well suited for valuing a business
that has both tangible and intangible assets, such as intellectual property, customer lists, valuable distribution rights, and the like.

The valuation multiples based on profitability, such as discretionary cash flow, EBITDA, or net income, will likely paint an unfavorable picture of what the business is worth.

Business valuation based on future income

Income based business valuation methods, such as the Discounted Cash Flow, are very well suited for valuing a business that currently runs at a loss.

This well-known method lets you calculate business value based on the company’s earnings forecast and risk assessment. Typical forecasts are done for 5 years, followed by the estimate of the business long-term (terminal) value.

Valuing a Business based on Cash Flow and Risk

Asset based business valuation methods

You can also use asset business valuation methods, such as asset accumulation or capitalized excess earnings. A well-established company may command considerable goodwill, despite the current slide in profitability. To calculate business goodwill, you will need to use the earnings estimate that represents the long-term business earning potential.

Your business valuation model may include a number of methods to determine what the business is worth. This multi-faceted approach is typical of professionally done business appraisals and tends to produce accurate, defensible results.

Business Valuation three Ways

If you are looking to sell your small business or plan to buy one, the central question is what the business is worth on the market.

Overprice your business, and you will see little buyer interest. If your asking price is too low, you risk leaving a lot of money on the table. Knowing the market value of your business helps you set the asking price that attracts qualified buyers - and results in a successful business sale.

Equally, if you want your offer to be taken seriously by the business seller, your price must reflect the realities of the business market place.

Beyond business acquisitions, business market value is key to establishing the business worth in a number of important situations - in legal disputes, business partner buyout situations, and in dealing with the tax authorities.

A solid evidence of what the business is likely to sell for if put on the market is often the most convincing proof of its value.

And there is no better way to estimate the likely business selling price than comparing it to the actual sales of similar private businesses.

Private business sales are very different from sales of public companies

Be careful looking at the sales of publicly traded companies when estimating the value of a private business. Valuation multiples for public companies are likely to be very different than those you get form private business sales.

Here are the top three reasons for this:

1. Small private businesses are less marketable than large public firms.
2. Small business sales are done on the controlling ownership basis. Most public company stock sales are non-controlling.
3. Small businesses are more risky and their valuation multiples reflect that.

Small businesses are less marketable than big company stock

If you own shares in a large publicly traded company, you can sell them within minutes by placing a market order through your broker. And you can get your money the next business day. More importantly, your actual selling price and the market price per share just before the sale are likely to be very close.

In contrast, selling a small privately owned business is a lengthy and uncertain proposition. Small businesses take 6 to 9 months to sell on average. Finding the right buyer, negotiating and closing the sale cost time, money and effort. And there is no certainty that your actual business selling price will be close to the asking price.

In formal terms, small businesses are illiquid investments, unlike shares of stock in pubicly traded companies, which are highly marketable.

This lack of marketability of small business ownership interest leads to significant discounts being applied by investors, such as financial business buyers. In other words, the buyers want to be compensated for taking the risk - and they do so by lowering the price they are willing to pay for a private business.

Valuation multiples you get by comparison to small business sales reflect this risk. Public company share price ratios do not.

Small business vs big business: what sells?

Most investors in public companies trade a small number of shares. When a large company is acquired, the buyer typically pays a premium for getting a controlling stake in the business. It is not unusual to see the control premium in the 50% - 80% over the market price of the company’s shares.

Almost all private business sales are done on the controlling ownership basis - the entire business sells. If you were to use the price per share numbers based on the public company data, you could be 80% wrong!

Again, valuation multiples derived from sales of similar small businesses are based on sales of the entire business. This is not the case for public company data.

Small businesses are more risky

For a proof of this take a look at the stock market to see that small firms tend to generate higher returns than, say, Fortune 500 companies. Put differently, investors use lower valuation multiples when pricing shares of smaller companies.

Best way to estimate business market value?

For accurate estimate of your business market value, you should use valuation multiples derived from the actual sales of similar small businesses. These businesses operate in the same industry, are privately owned, and are about the same size as your company.

Make relevant comparisons!

Such ”apples to apples” comparisons can give you a very reliable estimate of your what your business is worth on the market.

Business Market Value based on Small Business Sales

There are no better indicators of what a business is worth than its earning prospects and risk profile. Savvy investors analyze business opportunities by doing careful forecast of their income. But forecasts and money in the bank do differ in one key respect - there is a risk that the business may not live up to your expectations.

Hence, business value depends upon its risk assessment. Well-known income-based business valuation methods, such as the Discounted Cash Flow, let you account for the business risk directly - via the appropriate discount rate.

Alternatively, you can use the capitalization rate to factor in the company risk when valuing a business. The direct capitalization business valuation methods, for example the powerful the Multiple of Discretionary Earnings, let you do just that.

Since the discount and cap rates are related via the business growth rate, you can use both business valuation techniques.

Given the importance of company risk assessment via the discount and cap rates, how do you determine these important factors?

Do they depend on the economic conditions? Also, do the discount and cap rates change over time?

Each company has its own risk profile. Not surprisingly, the discount and capitalization rates for each business will differ. Here is how the discount rate is determined using the famous Build-Up formula:

1. Start with a risk-free return.
2. Add a risk premium for equity investment.
3. Add another risk premium for small company size.
4. Add a risk premum for the industry the company operates in.
5. Finally, add the company-specific risk premium.

Risk-free investments do pay!

Risk-free return means no risk of default. Investors like to use the current yields on long-term government debt obligations, such as the US Treasury bonds, as a measure of the current risk-free rate of return.

Even the most diversified stock investment portfolio is risky

You can examine the prevailing rates of return across the stock market to determine the additional returns the investors get for putting their money into publicly traded companies. This additional return is the premium required to keep investors interested in these companies, given their risk.

Small companies are riskier still

Small firms are seen as more risky than large ones. Again, you can study the market to see that the so-called “small cap” companies tend to generate higher returns. The additional return is the company size risk premium that can be used in the Build-Up formula.

Business risk varies by industry

Each industry has a set of unique risks that companies must overcome to be successful. You can study the returns in the specific industry in comparison to the stock performance across the entire market. The difference in the returns is the industry risk premium. Note that this number can be negative - if the industry is seen as less risky than the market as a whole.

Each company has its own risks

No company risk assessment is complete without analyzing its own set of strengths and weaknesses. Decisions made by the company management such as financial leverage, entering and exiting certain markets, hiring skilled staff, and making critical investments affect the company’s income prospects and its risk. Your goal here is to assess how these factors translate into the company-specific risk premium number.

Your business risk changes over time - so does business value

If you glance at the Build-Up formula elements, it is clear that the overall discount rate will vary over time.

Risk-free returns vary based on the prevailing interest rate climate. Public company fortunes change, so do their returns. Small companies may become a haven for investment money in some markets.

Industries go through cycles of expansion and contraction. And, of course, strategic decisions in the company itself affect its own risk.

It is a good idea to revise your risk assessment at least annually. This helps smooth over any transient effects in the markets and lets you spot important trends.

Tools to calculate the discount and cap rates

ValuAdder 4.0 business valuation software contains several tools you can use to assess the risk of any company.

Using the latest market data, ValuAdder financial recasting worksheets let you build up your discount rate, calculate your capitalization rate and account for the various business financing scenarios - with different costs of debt and equity capital. 

Business Valuation Tools

If you plan to acquire a small business, a central question is what the business is worth. Business valuation is the key step to determine your offer price and terms.

Business value: what happens after you buy?

In addition, understanding the target business economic value is essential to address some strategic questions after the purchase:

1. Which business value drivers are important?
2. What can you do to continue increasing business value?

Knowing what creates business value helps you focus your precious resources on things that matter most to your business worth. Smart allocation of resources is what sets apart successful business acquisitions from failures.

Approaches and methods to valuing a business for sale

Regardless of your acquisition target, you have 3 ways to determine the value of a business:

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

Business Valuation using Three Approaches

To get a reliable, accurate appraisal of business value you should use several methods under each of these key valuation approaches. This strategy is adopted in all professionally prepared business appraisals. The reason is that no one business valuation method is better then the others. Each approach lets you see the business against the background of important economic considerations.

Market based business valuation methods let you compare the target business against similar businesses that sold recently. Needless to say, this is a very compelling way to estimate your offer price!

Asset-based business appraisal methods, such as Capitalized Excess Earnings, help you determine whether the costs of buying the business are consistent with its true economic value. Should you pay the business seller’s price or build a similar business - and save?

Finally, the income-based business valuation methods, such as Multiple of Discretionary Earnings, let you look at the core of business value - its earning capacity and risk. The power of income based business valuation is that you can determine what the business is worth based on your specific business ownership objectives.

Structuring a business acquisition deal – cash is king!

Detemining the business value is one important step toward a successful business acquisition. To ensure that your business purchase works you need to structure the terms of your offer. The important questions your offer terms must address are:

• Does the business throw off sufficient cash flow to cover all my financial needs?
• Can the business service debt without difficulty?
• Is there enough cash to fund important capital expenses going forward?
• When do you get your down payment money back?

Structuing Your Business Acquisition

Debt service - margin of safety

The focus in your deal structuring analysis is on the business available cash flow. If you plan to fund the business acquisition with debt, whether from a lender or using seller financing, adequate debt service coverage is critical to your success. A key funding criterion by commercial lenders is debt service coverage ratio of at least 1.25.

Project costs - more than the business purchase price

Most small business acquisitions are so-called asset purchases. This means that you must account not just for the purchase price but provide for adequate working capital as well. You total outlay will also include the transaction costs of buying the business. The sum total of these three elements is your business acquisition project cost - which may exceed the contract purchase price by a hefty amount!

Can the busines pay the working owners?

Make sure that the business acquisition gives you a living wage. If a bank loan is involved in deal financing, your banker will certainly check if the business cash flow supports adequate salary for all new business owners.

Cash flow drain: deferred maintenance and equipment replacement

One key mistake to avoid is failing to allocate enough funds for new equipment purchases and other capital investments. You need to check the condition of business equipment and other hard assets and determine if they need to be replaced or upgraded in the near future. Unexpected capital expenditures can wreak havoc with your business finances!

Return of your investment

Smart business buyers and investors always want to see a return of their down payment. Make sure that business cash flow allows you to recover your investment within as short a period as possible.

As with successful business ownership, in business acquisition the golden rule is: cash is king!

If you are looking to have a business appraised hiring an appraiser is one of the ways to do it. As with any professional engagement the question of costs comes up rather quickly.

Not surprisingly, professionally prepared appraisals don’t come cheap; the average hourly rates these days are around $300. A well-done business appraisal takes about 20 hours or more. Do the math, and the price tag runs to $6,000 and up.

That’s not including any extra consulting time to present the business appraisal to partners, other professionals, prospective buyers, sellers or investors.

Instant business appraisals - too good to be true

What about those “instant” business appraisals for a few hundred dollars? Let the buyer beware: professional appraisal takes time. And time costs money. With a “minimum wage” business appraisal you quite literally get what you pay for.

So, can you get an accurate, defensible business appraisal and save?

Yes indeed! Given the right tools, you can do your business appraisal yourself - and save quite a bundle.

Most of the business appraisal cost is in the time the appraiser takes to do the work. And most of the time is spent understanding the business being valued.

Obviously, you can use your own knowledge of the business to cut down on time and costs. But what about the business valuation tools and knowledge?

A complete business valuation system

That’s where ValuAdder comes in. To make sure you can do your business appraisal yourself, ValuAdder gives you both the knowledge and tools to do it:

1. Complete business valuation software system. You can use the same valuation methods the professional appraisers use to calculate your business value.
2. A Learning and Information Center and 190-page Business Valuation Handbook. There is plenty of expert advice and guidance to get you through your business appraisal.

There is a Business Valuation Guide to introduce you to the fundamentals of business appraisal. Detailed Tutorials on valuation methods and helpful How-To Sections with examples. Every term is defined and explained in the Glossary.

To save you both time and money, ValuAdder is designed to simplify and speed up your business appraisal:

• Do split-second business market value comparisons in any of 400 industries.
• Determine business value based on its earnings and risk.
• Calculate business goodwill and total business value.
• Structure a successful business sale or purchase.
• Get tips on each input - right as you enter your numbers.
• Pick and choose the tools you want with a mouse click.
• Generate reports and share your business valuation results in the format you want: PDF, spreadsheet, Web page.

Latest word in valuation software reliability and accuracy

You may ask: how is all this possible? The short answer: state-of-the art technology and sound software engineering.

ValuAdder relies on the leading edge Java technology to give you a superior business valuation system - at a fraction of competitors’ costs:

Do your business valuation on any computer of your choice, in any currency

You can run ValuAdder on any Windows, Mac OS, Linux or Unix computer. ValuAdder naturally adapts to your computer preferences and settings - including multi-currency calculations.

Open Source technology saves you money

Java and Open Source lets us cut down dramatically on our development costs - and we pass the savings directly to you!

State of the art in security, reliability and accuracy

This technology also makes your ValuAdder an extremely stable, reliable and accurate business valuation software system.

Less support costs for us, better price for you!

Valuing a Business based on Income, Assets, and Market Comps

If you are looking at valuing an owner-operator managed small business, then the Multiple of Discretionary Earnings business valuation method should be high on your list of priorities.

One of the best examples of the so-called direct capitalization valuation methods, this method determines the value of a business as a multiple of its discretionary cash flow.

One of the greatest strengths of this well-known business valuation method is an excellent match it provides between the business earnings and a broad range of financial and operational performance factors.

You can get very accurate business valuation results with this method. Equally important, you can see how the business value is affected by the quality of the operation.

Balance sheet inputs that affect business value

For highly accurate results, you also need to provide several financial values from the company’s recast balance sheet.  These include:

1. Net working capital.
2. Non-operating assets.
3. Long-term liabilities.

For the purposes of your business valuation, Net Working Capital is the difference between the business current assets, less inventory; and its current liabilites, less the short-term portion of the long-term debt. Essentially, this represents the liquid capital used by the business owners for short-term financing.

Non-operating assets may include such items as business-owned real estate, excess inventory and underutilized production or distribution capacity. The idea is that the business asset base should be adequate to support its level of earnings. All assets that are not used to generate these earnings are extra - and can become additional and valuable parts of a business acquisition.

If you value a debt-free business, the long-term liabilities are zero. However, if the business uses financial leverage, then your business valuation must factor in these liabilities. The result is the value of business owners’ equity interest in the business.

If you bought or sold a small business before, you may notice that Multiple of Discretionary Earnings method measures the business value on an asset sale basis. In fact, most small business sales are asset transactions.

In these cases, the business assets, less cash and trade receivables, transfer to the buyer. The seller pays off all business liabilities to deliver these assets free and clear. Non-operating assets may be valued separately and included in the deal.

Perhaps the greatest advantage of the renowned Discounted Cash Flow business valuation method is its flexibility. You can choose any stream of business income and discount it to determine the business value today. However, to get accurate business valuation results, you need to match your earnings and the discount rate carefully.

Net cash flow and build-up discount rate formula

Most business appraisal experts recommend the net cash flow as the earnings basis for use with the Discounted Cash Flow method. The widely accepted rationale is this:

The discount rate, which captures your business risk, is typically derived from the public capital markets. The investors in these markets generally obtain the economic benefits equivalent to the net cash flow. Hence, the use of net cash flow to ensure that the earnings basis and discount rate are matched.

That said, you can make an adjustment to the discount rate and then use it to discount a different income stream, such as the seller’s discretionary earnings.

In this case the discount rate will need to account for the additional opportunity cost of owning and operating the business. This cost is not included in the Build-Up cost of capital formula directly - since typical investors do not work in their portfolio businesses.

Once matched, the two sets of income streams and discount rates should provide you with comparable results.

Discretionary earnings and capitalization rate that match well

In comparison, the Multiple of Discretionary Earnings, a widely used direct-capitalization method, uses the seller’s discretionary cash flow as the earnings basis. The capitalization rate is developed from the 14 business financial and operational factors you specify.

This cap rate is matched specifically to the seller’s discretionary cash flow as the earnings basis. An important difference from the net cash flow is that SDCF includes the single owner-operator compensation and non-recurring business expenses as addbacks.

If you are buying a business or selling your business, estimating the business selling price by market comparison is a good idea. Recent business sales in your industry offer an excellent way to develop your asking price or check your offer price and terms.

A number of business pricing multiples to choose from

As we discussed in the Business Valuation using Market Comps post, you have a number of valuation or pricing multiples to do your comparisons. Which ones work best?

How to pick your pricing multiples

The answer depends on your business valuation situation. Your choice of the valuation multiples needs to address these important questions:

1. Which pricing multiples give the most accurate prediction of business market value?
2. Which valuation multiple gives the best estimate of what my business is worth?

In the market, business selling prices are set by the business sellers and buyers. So what do these players use as their basis to determine the business value?

Valuation formula multiples are developed by statistical analysis of the actual business sales. Let’s say that in your industry the Price to Gross Revenue valuation multiples cluster around the average value. In other words, business values determined using such pricing multiples fall within a narrow range.

This means that your business peers tend to rely on the business gross revenues to determine the business selling price. Knowing this, you can use the Price to Gross Revenue valuation multiple to get a good idea of what your business is worth.

Obviously, such pricing trends can differ by industry. ValuAdder market-based Valuation Formulas use advanced technology to help you make the most accurate choice of the valuation multiple for your business.

Business valuation multiples - making strategic choices

You can use a number of other business valuation multiples as a strategic choice to demonstrate your business value.

For example, the business may be exceptionally profitable compared to its industry peers. In such a case, you may decide to use the Price to Net Income or EBITDA valuation multiples which will show how profitability translates into superior business market value.

If the business is asset rich, business Price to Tangible Assets or Total Asset base may be a good choice of a pricing multiple.

Alternatively, you can pick the Price to Gross Profit valuation multiples. This may be a good fit if the business shows outstanding operational efficiencies which keep its direct costs low compared to the competition.

Take a peek at ValuAdder Business Valuation Market Comps Tool to see how a number of business valuation multiples can be used to estimate your business market value.