Business Valuation Methods

Definition

A set of procedures or techniques used to determine the business value.

What It Means

Under each of the three broad approaches to business valuation, there are a number of procedures, called business valuation methods, which you can use to calculate the business value.

The methods under each business valuation approach rely upon the same set of economic principles. However, the procedural and mathematical details of each business valuation method may differ considerably.

Asset-based business valuation methods

Sometimes referred to as the cost-based methods, these business valuation methods estimate the value of a business as the sum total of the costs required to create another business of equal economic utility.

Asset based business valuation methods are useful for accurate business purchase price allocation, an important element of structuring a business acquisition deal.

The central methods under the asset approach are these:

  • Asset accumulation method
  • Excess earnings method

The asset accumulation method is a framework for tabulating the market values of business assets and liabilities. The difference is the business value. Note that the method differs from the typical cost basis accounting balance sheet.

Important off balance sheet assets include the internally developed intellectual property, customer lists, and valuable business agreements. On the other side, the method accounts for contingent liabilities such as pending legal action judgments and costs associated with regulatory compliance.

A classical asset based business valuation method is Capitalized Excess Earnings, also known as the Treasury Method. In addition to business value calculation this method lets you determine the value of business goodwill.

Income-based business valuation methods

The income methods, as the name implies, determine the business value based on its income producing capacity and risk.

The main business valuation techniques used by these methods are capitalization and discounting. Business risk is captured in the form of discount and capitalization rates.

Income business valuation methods most commonly used in business appraisals are:

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

The well-known capitalization method is Multiple of Discretionary Earnings. The Discounted Cash Flow business valuation method is the most common way of determining business value by discounting its income.

Market-based business valuation methods

These methods help you estimate the subject business value by comparison to the recent selling prices of similar businesses.

Professional business appraisals often include these market valuation methods:

  • Guideline publicly traded company method
  • Comparative transaction method

Both types of methods work by comparing the subject business to similar companies that sold recently. For private companies, the sales of similar privately owned businesses can offer a compelling source of market comparables. However, the quality of such data is usually not nearly as reliable as transaction data filed by public companies. Transactions involving small capitalization public companies are often used as evidence of business value for privately owned firms.

Valuation Formulas derived from comparable business sales are a standard way to determine the business fair market value.

Use of multiple methods in business appraisals

Using a number of business valuation methods is highly recommended for accurate determination of business value.

To conclude what a business is worth, you can take the results of several business valuation methods into account. This process is often referred to as business value synthesis.

See Also