Business Valuation: the Three Approaches
What is business valuation?
Quite simply, business valuation is a process and a set of procedures used to determine what a business is worth. While this sounds easy enough, getting your business valuation done right takes preparation and thought.
Business valuation results depend on your assumptions
For one thing, there is no one way to establish what a business is worth. That’s because business value means different things to different people.
A business owner may believe that the business connection to the community it serves is worth a lot. An investor may think that the business value is entirely defined by its historic income.
In addition, economic conditions affect what people believe a business is worth. For instance, when jobs are scarce, more business buyers enter the market and increased competition results in higher business selling prices.
The circumstances of a business sale also affect the business value. There is a big difference between a business that is shown as part of a well-planned marketing effort to attract many interested buyers and a quick sale of business assets at an auction.
Expected selling price and business value
Hence, business value is really an expected price the business would sell for. The real price may vary quite a bit depending on who determines the business value. Compare a buyer who wants the business now because it fits important lifestyle goals to a buyer that purchases an income stream at the lowest price possible.
The selling price also depends on how the business sale is handled. Contrast a well-conducted business marketing campaign and a “fire sale”.
Three business valuation approaches
That said, there are three fundamental ways to measure what a business is worth:
- Asset Approach
- Market Approach
- Income Approach
The asset approach views the business as a set of assets and liabilities that are used as building blocks to construct the picture of business value. The asset approach is based on the so-called economic principle of substitution which addresses this question:
What will it cost to create another business like this one that will produce the same economic benefits for its owners?
Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets and liabilities. The difference is the business value.
Sounds simple enough, but the challenge is in the details: figuring out what assets and liabilities to include in the valuation, choosing a standard of measuring their value, and then actually determining what each asset and liability is worth.
For example, many business balance sheets may not include the most important business assets such as internally developed products and proprietary ways of doing business. If the business owner did not pay for them, they don’t get recorded on the “cost-basis” balance sheet!
But the real value of such assets may be far greater than all the “recorded” assets combined. Imagine a business without its special products or services that make it unique and bring customers in the door!
The market approach, as the name implies, relies on signs from the real market place to determine what a business is worth. Here, the so-called economic principle of competition applies:
What are other businesses worth that are similar to my business?
No business operates in a vacuum. If what you do is really great then chances are there are others doing the same or similar things. If you are looking to buy a business, you decide what type of business you are interested in and then look around to see what the “going rate” is for businesses of this type.
If you are planning to sell your business, you will check the market to see what similar businesses sell for.
It is intuitive to think that the “market” will settle to some idea of business price equilibrium - something that the buyers will be willing to pay and the sellers willing to accept. That’s what is known as the fair market value:
The business price that a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, and neither being under compulsion to conclude the sale.
So the market approach to valuing a business is a great way to determine its fair market value – a monetary value likely to be exchanged in an arms-length transaction, when the buyer and seller act in their best interest. Market data is great if you need to support your offer or asking price – after all, if the “going rate” is this much, why would you offer more or accept less?
The income approach takes a look at the core reason for running a business – making money. Here the so-called economic principle of expectation applies:
If I invest time, money and effort into business ownership, what economic benefits and when will it provide me?
Notice the future expectation of economic benefit in the above sentence. Since the money is not in the bank yet, there is some measure of risk – of not receiving all or part of it when you expect it. So, in addition to figuring out what kind of money the business is likely to bring, the income valuation approach also factors in the risk.
Since the business value must be established in the present, the expected income and risk must be translated to today. The income approach uses two ways to do this translation:
Business valuation by direct capitalization
In its simplest form, the capitalization method basically divides the business expected earnings by the so-called capitalization rate. The idea is that the business value is defined by the business earnings and the capitalization rate is used to relate the two.
For example, if the capitalization rate is 33%, then the business is worth about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. Either way, the result is what the business value is today.
Valuation of a business by discounting its cash flows
The discounting method works a bit differently: first, you project the business income stream over some future period of time, usually measured in years. Next, you determine the discount rate which reflects the risk of getting this income on time.
Last, you figure out what the business will be worth at the end of the projection period. This is called the residual or terminal business value. Finally, the discounting calculation gives you the so-called present value of the business, or what it is worth today.
Business valuation and risk: discount and cap rates are related
Since both income valuation methods do the same thing, you would expect similar results. If fact, the capitalization and discount rates are related:
where CR is the capitalization rate, DR is the discount rate, and K is the expected average growth rate in the income stream. Let’s say that the discount rate is 25% and your projections show that the business profits are growing at a steady 5% per year. Then the capitalization rate is 25 - 5 = 20%.
Perhaps the biggest difference between capitalization and discounting is what income input you use. Capitalization uses a single income measure such as the average of the earnings over several years. The discounting is done on a set of income values, one for each year in the projection period.
If your business shows smooth, steady profits year to year, the capitalization method is a good choice. For a growing business with rapidly changing and less predictable profits, discounting gives the most accurate results.
How business valuation methods can produce different results
Is it possible to use the income business valuation methods and arrive at different results? Yes indeed! Consider two prospective business buyers doing the income projections and assessing the risk of owning a given business.
Each buyer will likely have a different perception of the risk involved, hence their capitalization and discount rates will differ. Also, the two buyers may have different plans for the business, which will affect how they project the income stream.
Thus, even if they use the same valuation methods the resulting value conclusions may be quite different. Put another way, the two buyers apply the so-called investment value standard to determine the business worth. They measure the business value differently, based on their unique ownership or investment objectives.
This flexibility of measuring the business worth to match one’s objectives is one of the greatest strengths of the income valuation approach.