We are often asked: what business valuation methods are best for a specific industry? Since the standard valuation methods can be used to value any business, a better question is what choices work best to value a particular company, regardless of the industry it’s in.
If you have seen a professionally prepared business appraisal report, you should have spotted that a number of valuation methods were used to determine the business value. That’s because no one method provides an all-conclusive answer. A combination of methods in your analysis helps to consider what the company is worth from a number of perspectives.
The income based methods focus on the company’s ability to generate returns for its owners given an acceptable level of risk. The asset approach helps you view the business as a set of valuable assets, whereas the market methods compare the company to other similar firms.
Each valuation method may provide a useful insight into business value. In some cases, certain methods tend to be more compelling than others.
Consider a start-up company with a unique set of technologies that set it apart from competition. Clearly, comparing it to other firms is not useful since the company is very different. In this case the market comparisons are not useful. You should instead focus on analyzing the company’s own ability to generate earnings and its unique asset base.
The situation may be very different when valuing established companies in well developed industry sectors. A restaurant can easily be compared to other businesses similar to itself. So market based valuation methods are very useful here as they help you determine the restaurant value in comparison to other similar businesses.
Cash cow businesses that generate predictable earnings time and again are great candidates for valuation with direct capitalization methods such as the multiple of discretionary earnings. On the other hand, fast growing firms are best valued using the discounted cash flow method.
When in doubt, remember that using a number of valuation methods is the best way to determine company value. Each method offers you a unique view of business worth. Having the results from a number of methods is a solid way to draw a defensible business value conclusion.
Business Valuation Using Several Methods
The subject of business valuation comes up all the time whenever the sale of a company is planned. Both business owners and buyers feel they need to know what the business is worth before making any commitments.
You might conclude that the business selling price should be defined entirely by the number that represents business value. After all, why would owners part with the valuable company for anything less than it is worth? Or how can a business investor offer more money for the company that its valuation indicates?
Yet time and again, business people are surprised to find that the actual business selling price differs from the business value. Moreover, the price the company sells for depends upon the particular deal struck between the buyer and the seller. Why would this be the case?
The short answer is that both the seller and the buyer have specific goals in mind. In addition, both parties to the business sale may have constraints that they need to meet as part of the deal.
Consider just some elements that make or break a typical private business sale:
- Buyer down payment amount
- Whether the seller is willing to carry a note to the buyer
- Availability of a bank loan on reasonable terms
- Payback period indicating the return of buyer’s down payment
- Capital investments anticipated by the buyer once the business changes hands
- Working capital needed from the buyer
- Transaction costs the buyer incurs to close the deal
In most cases the available business cash flow must cover all the requirements above for the deal to make financial sense. Debt service on the bank loan and seller financing is a major cash flow drain the buyer must reckon with. This is an additional burden on the company that the seller has not needed to contend with. So the same company must now produce the additional returns to cover this new requirement.
Business buyers often envision expanding the operation to reach their goals. Such growth plans typically require new capital outlays the original owners did not expect. The buyer can either draw this capital from the company’s reserves or inject the funds from other sources. Either way, the amount of the money required makes a difference as to how attractive the business purchase is. Clearly, the lower the business selling price, the more resources the buyer could potentially commit toward the business expansion.
A financially minded business buyer would expect the return of the initial cash down payment within a reasonable time period. The shorter this period, the more cash flow the company must generate for the payback. It is possible that the buyer would negotiate for a lower business selling price in order to recover the down payment quicker.
There are cases where the business sells for a price much higher than its current value. The company could be enjoying a highly attractive position in the market because of its unique products or services. This makes it very interesting to a number of well funded competitors. This competition can easily drive up the eventual selling price for the firm.
Unique or innovative technology make make the company a highly desirable acquisition target for large public firms. The business selling price in such cases can be many times over what a private transaction would bring. The reason is that the public companies have the ability to exploit new technologies in ways that are beyond the means of private businesses. They can create new products, access already developed markets, or take advantage of economies of scale they already enjoy.
In many business sales the business value established by a formal appraisal is just a starting point in negotiations. Both the buyer and seller need to come to reasonable terms to make the sale work. The ultimate business sale price is a compromise between the theoretical company’s value and the ability of the parties to settle on acceptable price and terms.