Business valuation methods in a bad economy
I think you will agree – we are seeing the most unprecedented changes in the economic environment in recent history. And unlike the earlier downturns, the effect is felt across all industry sectors and by most businesses, large or small.
Business people are rightly concerned to ask: how does this affect my business value? Importantly, what are the best ways to determine the business value in a bad economy?
Three ways to value a business – in any economy
Let’s consider the options. There are three ways, known as business valuation approaches, that you can use to value a business:
- Market – by comparison to recent sales of similar businesses.
- Income – determing the business value based on the income outlook and company risk.
- Asset – based on the costs of business assets and liabilities.
Market business valuation methods
If you need a defensible business valuation in a changing market – consult the market directly. For private companies, the most compelling valuation method is to compare against the recent sales of similar private businesses.
When the economic outlook is cloudy, such market comparisons offer the sanity check of business value – based on the market-wide perception of earnings prospects and risk by your peers – the business people brave enough to buy, sell or merge small businesses!
This business valuation method is so important that is has a formal name in the professional business appraisal community: Comparative Transaction Method.
Income business valuation methods
When market uncertainty is high, you need to review your business earnings forecast and re-assess the risk going forward. This is precisely what you can do using the Discounted Cash Flow business valuation method. Detailed business risk assessment lets you incorporate such important elements as the business size, industry segment and company specific risk.
How accurate your business valuation result is depends on the quality of your income projections and business risk assessment.
It is a good idea to run a few what-if scenarios – each using a different possible outcome. A worst case – best case analysis is typical. Your business value can then be calculated either as a range or a single number equal to the average of the two valuation results.
You can also use direct capitalization methods such as the Multiple of Discretionary Earnings to value a business. Make sure, however, that your earnings basis reflects the economic reality. The method allows you to assess such key risk factors as stability of business earnings, competitive position, market and product concentration.
Asset business valuation methods
The Asset Accumulation method, while useful for purchase price allocation among the various business assets, is difficult to apply in a tough economy. The reason is that appraising the value of individual business assets and liabilities may be difficult.
A better business valuation method is Capitalized Excess Earnings. Using this method you can determine the value of business goodwill and the total business value – by accounting for the business assets, while keeping a close eye on its earnings and growth outlook.