Income valuation for the sale of a business
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 will likely go south.
You have a choice of three approaches to business valuation, namely the asset, income, and market. And 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. So figuring out if you get the financial returns for all your trouble forms the foundation of income based valuation. Importantly, 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 represents the other key element of measuring business value. If you anticipate some income in the future, how do you know you will get it on time and in full measure? This depends the risk of the business investment.
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.