Perhaps the best known reasons for getting a business valuation are a business sale or purchase and handling a legal challenge such as divorce or partner dispute.
You can also use business valuation as a strategic planning tool. And one of the most important questions to address is whether you should keep your doors open or wind the business down.
Using business valuation for strategic decision making
So how can business valuation help you make this critical decision? In addition to giving you a number, business appraisal shows how well the business creates value for its owners.
One of the central questions: is running the business worth the effort? Or, using the business appraisal terminology: does the business create enough value for its owners?
Enter the Capitalized Excess Earnings business valuation method. Known as the Treasury Method, this classical valuation technique lets you determine the value of business goodwill and total business value.
Here is how the method works:
- First, it identifies the value of business tangible assets. Essentially, this is the capital committed to support the business operations.
- It calculates the return required given the business investment made.
- Next, it determines whether the business is profitable enough to generate additional earnings, known as excess earnings.
- Based on these excess earnings and business growth prospects, it calculates the value of business goodwill.
- Finally, it determines what the business is worth.
Notice that business goodwill depends on the company’s earning capacity. The total business value then is the sum of its tangible assets and goodwill.
Put another way, the business must first pay for the capital invested by the owners and then generate additional earnings to make it worth while – over the long term.
This gives you a way to address the question of whether running the business makes economic sense:
If the business goodwill is positive, your business produces enough earnings to justify your efforts.
On the other hand, zero or negative goodwill value shows that the business is having trouble paying for the investments already made – including cash, inventory, equipment and facilities.
Is the business worth the trouble in the long run?
Given the long-term view of business value you get from the Capitalized Excess Earnings method, you can make the decision:
- If the business generates sufficient earnings to cover your long-term investment and produce significant goodwill, it is worth the trouble to continue running it. The business will likely increase in value to make it an attractive acquisition target in the future.
- If business earnings fall below the expected returns on your investment, it may be time to wind down the current operations or plan for stratetic changes in the company.