Archive for October, 2018

Putting the business on the market? Valuing the business to set the right asking price or make an acceptable offer is half the battle. Stray but a little and the deal is bound to go south.

You have a choice of three approaches to business valuation, namely the asset, income, and market. Of these three ways, measuring business worth based on its income goes to the core of why businesses are created – putting money into the owners’ pockets.

Smart business people always look for the best opportunity to invest their hard earned money. Figuring out if you get the financial returns for all your trouble is what income valuation is all about. You can review a number of business opportunities and measure their value by comparing their ability to generate income at an acceptable level of risk.

Risk in investment is the other key element of measuring business value. If you anticipate some income in the future, how sure are you of getting it on time and in full measure? This depends on how risky the business investment is.

In formal business appraisal terms, you need to come up with both the estimate of future earnings and the measure of business risk, usually expressed as its discount or capitalization rates.

For a given level of expected earnings, the higher the risk, the larger the discount or cap rates and the lower the business value. Put another way, a riskier business needs to generate higher earnings to justify your investment. You could decide the risk is just too high and put your money into a different business opportunity that promises perhaps somewhat lower but more predictable returns.

How to calculate business valuation

Income based business valuation can be done two ways. You can calculate the so called present value of the company by discounting its earnings. As an alternative, you could capitalize business earnings by dividing them by the capitalization rate.

Business valuation by discounting its cash flow

Generally, businesses with widely fluctuating earnings are best valued by the discounted cash flow method. This lets you focus in on the effect the earnings in each time period have on business value.

Single period capitalization methods

If the company is the proverbial cash cow with steady cash flow thrown off year after year, you can get pretty accurate valuation by the simpler capitalization methods.

What if you can envision a number of scenarios in the future that affect business earnings and risk? Things like competitive pressure, new product introduction, or regulatory approval that’s on the horizon?

Assessing the worth of your business

You can assess business value in each case by running a separate what-if valuation calculation. Generate your income forecasts and assess discount and cap rates for each possible outcome. Then calculate your business value and assign a weight to the result based on the likelihood of each scenario actually panning out.

This gives you either a single business value number or a range of values from low to high. If you have done your homework well, the actual business value will fall somewhere in the range.

In the context of business valuation, this is more commonly referred to as excess earnings. Do not confuse it with the notion of business people making more than they should. Excess earnings is a technical term and it plays a central role when valuing a business under the asset approach.

This valuation method is formally known as the capitalized excess earnings technique. The idea behind the method is that superior business performance goes hand in hand with above average profitability. Established companies that excel at their game tend to command the loyalty of customers who are less price sensitive than the comparison shoppers ready to jump on the best deal from anyone.

Superior earnings indicate business goodwill

Higher earnings also underlie the concept of business goodwill. The idea is that business value is higher than the sum total of its assets. In a highly profitable company, the total business value is above the sum of its parts. This difference is business goodwill.

Measuring business goodwill is where the excess earnings come in. Business owners are viewed as investors who supply the capital needed to operate the company. As investors, they would expect a fair rate of return on this committed capital.

Top performing companies possess lots of goodwill

But highly successful companies do one better. In addition to providing their investors with a fair return on their money, these great businesses throw off additional earnings. To measure business goodwill, you would capitalize these excess earnings by the company’s capitalization rate.

Goodwill is part of total business value

The total business value then is the sum of the company’s key operating asset values plus business goodwill. The beauty of the capitalized excess earnings valuation method is the ability to translate exceptional performance into business value as the sum of invested capital assets and the intangible business goodwill.

Here is to the business owners with vision and dedication to create highly successful companies. They don’t rake in excess income, they produce excess earnings and a lot of valuable business goodwill.