Archive for September, 2009

If you talk to a professional business appraiser, it won’t be long before you hear about the business valuation approaches and methods. These are the tools of the trade – and it is important to understand their relationship.

Business appraisers enjoy having an arsenal of tools at their disposal. This gives them the flexibility to appraise just about any type of business or professional practice. Much of the appraiser’s expertise is in the proper selection of the right tools for each assignment.

Being highly organized people, the business appraisers like ordering things. So here is the basic taxonomy of the business valuation tools.

Business valuation approaches

At the top of the pile are the three ways to measure the value of a business:

  • Asset Approach
  • Income Approach
  • Market Approach

Each approach lets you adopt a different view of what a business is worth. As the name implies, the Asset Approach looks at the values of business assets in order to determine the value of the entire company.

The Income Approach lets you measure the value of a business based on its ability to generate earnings at an acceptable level of risk.

Finally, the Market Approach offers you the way to estimate the market value of your business – by comparison to similar businesses that have recently sold.

Business valuation methods

When it comes to the actual calculation of business value, the business appraiser reaches to an array of techniques known as methods. Each major approach has a number of methods under it. The methods are the actual computational procedures you can use to calculate the monetary value of your business.

Here are the major business valuation methods grouped around their approach:

Asset-based business valuation methods

Income-based business valuation methods

Market-based business valuation method

Best practice: multi-method business valuation

The methods differ in the fundamental approach and the details of the calculations. Since no method is better than the others, well-prepared business appraisals use a number of methods to round out their conclusion. Using a set of methods under each Approach is the best way to “cover all bases” – and get a highly accurate, defensible business appraisal.

Multi-Method Business Valuation

If you own an established industrial equipment rental and leasing business, plan to buy one or need to provide a business appraisal for a client, consider adding the market-based valuation methods to your toolkit.

Classified under the SIC code 7377, profitable firms operating in a well defined, protected niche, are quite valuable and sell often. This means that there are plenty of business sale comparables you can use to estimate what your company is worth. Indeed, comparison to recent sales of similar businesses offers your the most convincing way to determine and prove the value of your own business.

Business valuation by the Comparative Transactions Method

This market-based technique is formally called the Comparative Transaction Valuation Method. The typical tools are a range of valuation multiples derived from past business sales.

These multiples relate the actual business selling prices to some measure of financial performance, including the equipment rental business gross revenues, net sales, gross profit, net income, EBIT and EBITDA, discretionary cash flow, assets and owners equity.

Once you know the valuation multiples for your business, you can calculate the fair market value of your firm by applying the multiples to your company’s financial performance parameters.

For example, if the median price to gross revenues multiple is 0.4 and your company’s current gross revenues are $4,000,000; then the estimated business value is $1,600,000. You can apply other multiples to refine and cross-check your estimate.

Example: market-based valuation of an equipment rental business

Let’s take a typical privately owned equipment rental and leasing firm with the following financials:

  • Gross revenues: $4,000,000.
  • Net sales: $3,750,000.
  • Gross profit: $1,200,000.
  • Net income: $50,000.
  • EBIT: $80,000.
  • Seller’s discretionary cash flow (SDCF): $270,000.
  • Inventory: $620,000.
  • Total assets: $1,500,000.
  • Owners’ equity: $700,000.

For this example, we pick a set of reasonable valuation multiples as follows:

  • 0.4 times the business gross revenues.
  • 0.45 times the net sales.
  • 1.25 times the gross profit.
  • 25 times the net income.
  • 17 times the EBIT earnings.
  • 1.7 times the SDCF (SDE).
  • 1.3 times the business total assets.
  • 3.5 times the owners’ equity.

Applying these multiples to the company’s financials above, we get the following business valuation results:

Multiple Multiple value Business value
Price to gross revenue 0.4 $2,220,000
Price to net sales 0.45 $1,687,500
Price to gross profit 1.25 $1,500,000
Price to net income 25 $1,250,000
Price to EBIT 17 $1,360,000
Price to SDE 1.7 $1,079,000
Price to total assets 1.3 $1,950,000
Price to owners equity 3.5 $2,450,000
Average Business Value $1,687,063

A single number or a range of business values

Note that calculating the average is just one way to assess what your business is worth. You can also use the set of business valuation results to establish a range of values, from low to high. In this example, your company’s market value is likely to be between $1,079,000 and $2,450,00.

Using Market Comps for Business Valuation

Our customers often ask us this question:

ValuAdder offers a number of business valuation methods. Does using multiple valuation techniques reduce business risk?

Our answer is this: applying a number of methods to value a business helps you reveal and assess the business risk much better than using just one method.

Appraising a business based on its cash flow

Let’s say that you are valuing a company and decide to use the Discounted Cash Flow method. This method relies on the discount rate for business risk assessment. The classical Build-Up model to calculate the discount rate works as follows:

  1. Start with the risk-free rate of return. The yield on long-term US Treasuries is a common choice.
  2. Add the equity risk premium – the additional return you get investing in the stock market.
  3. Add the premium for company size – since smaller firms tend to be riskier than Fortune 500’s.
  4. Add the industry-specific risk premium.
  5. Assess the company-specific risk and add the corresponding premium.

Usually, the company-specific risk assessment is the hardest part, and the greatest cause of mistakes. Needless to say, improperly calculated discount rate will give you erroneous business valuation results.

A different perspective – market based business valuation 

To verify the results your get with the Discounted Cash Flow method, you may consider using the market-based valuation techniques. Here, you study the recent sales of comparable companies. You can see how other business people assess risk by calculating the valuation multiples they applied when valuing the businesses they bought or sold.

Review of statistically derived valuation multiples gives you an idea of the levels of risk for companies similar to yours. While each business is unique, sharp deviations from the industry norm call for an explanation and may point out an error in your analysis.

Asset based business appraisal – another view of business value 

You can also add asset-based valuation methods to shed further light on business risk. For example, using the Capitalized Excess Earnings Method shows just how well the business generates returns for its owners, given the capital invested.

Notice that the various methods adopt a very different view of business value. Yet all these different perspectives complement each other to expose the same fundamental drivers of business value – risk and return. 

Business Valuation using Multiple Methods

If you want a business appraised by a qualified business analyst, you are presented with a bewildering array of choices. There are no local or federal license requirements for business appraisers.

Instead, a number of professional organizations offer education and professional certifications for appraisers. Each organization has its own set of appraiser endorsement requirements and guidelines on how its members should conduct business valuations for clients.

Just about all these organizations follow the accepted standards, most notably the Uniform Standards of Professional Appraisal Practice or USPAP for short, which are published by the Appraisal Standards Board of the Appraisal Foundation.

Here are the major business valuation organizations that train and certify appraisers in North America:

American Society of Appraisers

Founded in 1952, ASA is perhaps the most recognized professional organization of business appraisers. It covers a number of disciplines including the appraisal of real estate, machinery and equipment as well as business valuation.

The accredited members receive a number of designations:

  • Accredited Member or AM.
  • Accredited Senior Appraiser or ASA.
  • Fellow of the American Society of Appraisers, abbreviated FASA.

In addition to extensive coursework and qualifying exam, these designations require significant full-time business appraisal experience.

The Society has local chapters throughout the US and Canada.

Institute of Business Appraisers

IBA has been founded in 1978 with the purpose of educating and certifying appraisers with the primary focus on small businesses and professional practices. The Institute offers extensive business valuation training. Those completing the training and successfully passing an exam can receive these designations:

  • Certified Business Appraiser, CBA.
  • Business Valuation Accredited for Litigation, or BVAL.
  • Fellow of the Institute of Business Appraisers, FIBA.

American Institute of Certified Public Accountants

AICPA views business valuation as a specialized type of accounting services. In addition to publishing the major business appraisal standard, AICPA SSVS No 1, the Institute offers a full-fledged certification program for its CPA members who wish to practice business appraisal.

The accreditation conferred is known as Accredited in Business Valuation or ABV. It requires that the members complete several valuation related courses and successfully pass a two-day exam.

National Association of Certified Valuation Analysts

NACVA, founded in 1991, has members that are mainly CPAs and non-CPA appraisers in private practice as well as government service. Extensive training and qualification exam are offered leading to the Certified Valuation Analyst (CVA) accreditation.

The Canadian Institute of Chartered Business Valuators

The leading business appraisal organization in Canada, the Institute offers in-depth training and rigorous examination to certify its members as Chartered Business Valuators (CBV). Additional educational requirements are typically a college degree.

The answer depends on your situation.

If you need a recipe for an accurate, defensible business valuation make sure you choose a number of professionally accepted business valuation methods to do it.

Valuing a business requires that you carefully analyze the company across a number of economic fundamentals. Professional business appraisers approach business valuation in three ways:

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

Selecting and applying a number of proven valuation methods under each approach gives you a comprehensive view of the business value.

Using the asset-based methods such as the Asset Accumulation or Capitalized Excess Earnings, you can determine the company’s value based on the values of its assets.

The income valuation methods let you estimate the value of the company based on its earning capacity and risk. On the other hand, the market based appraisal methods focus on comparison of your business to similar firms that have sold recently.

All these methods take a different view of what drives business value. No one method is better than the other. That is why selecting a number of valuation methods is the best way to create a sound business valuation.

Given all the method choices, which ones should you pick? This depends on your specific business situation. Here are some suggestions:

Start-up valuation

Valuing a young company presents unique challenges. Since most comparable business sales involve established firms, it makes little sense to use the market-based valuation methods.

Asset based valuation methods focus on establishing the value of the business based on a proven, optimized asset base. Often, business goodwill is a large part of business value, especially for businesses in the service industry. Yet it takes time to build goodwill in a business.

A start-up’s value depends on its potential to generate future earnings at an acceptable risk. This leaves you with the income-based valuation method choices. One of the best ones is the Discounted Cash Flow method. You can calculate your business value based on a number of earnings forecasts, each with its own risk profile represented by the appropriate discount rate.

Business valuation of an established cash cow company

Established firms that tend to generate reliable, steady income streams are very desirable. As a result, they are frequent acquisition targets. This gives you plenty of business sale comparables data to make an accurate business market value assessment.

Direct capitalization methods, such as the Multiple of Discretionary Earnings method, are an excellent choice for valuing companies with stable, recurring earnings.

Steady earnings tend to be associated with a large, loyal customer base. The business becomes an institution in its market place which creates considerable goodwill. You can use the famous Treasury Method to calculate the value of business goodwill and total company value.

Valuing an owner-operator managed small business

If your business operates in the service, retail or wholesale industries, comparable business sales abound for small, successful companies. Market based business valuation methods work very well in valuing such firms.

The Multiple of Discretionary Earnings method is a very common choice under the income approach. In addition to the business earnings, the method lets you determine the business value based on a number of financial, operational and lifestyle factors.

Professional practice valuation

Professional practices are a special type of service firms. Perhaps the biggest difference is that they tend to create considerable business goodwill. If you need to appraise a medical or dental practice or an accounting firm, the Capitalized Excess Earnings method should be high on your list.

For larger practices the Discounted Cash Flow method is the typical choice. On the other hand, you can value a single practitioner firm using the Multiple of Discretionary Earnings method.

Business Valuation using a Set of Methods

See how a number of established methods can be used to create a top quality business appraisal.

Find Out More »