Business Valuation: The Three Approaches
What is business valuation?
Quite simply, business valuation is a process and a set of procedures used to determine what a business is worth. Sounds straightforward? But the devil is in the details – to create a credible business valuation you need knowledge, preparation, and a good deal of thought.
Assumptions drive your business valuation results
To make things interesting, there are a number of ways to measure business value. Why such complexity? Because business value is seen differently by different people.
For example, a business owner may believe that the business value is defined by its contribution to the local community it serves. On the other hand, a financially minded investor may gauge a business solely based on its ability to generate desired returns.
Business value does not stand still. Market conditions change all the time and business people may see greater value in companies as their fortunes shift. It is common knowledge that competition for private businesses increases when jobs are scarce as more people enter the business buying market in search of income. This tends to drive up the business selling prices. Supply and demand, anyone?
What is the ultimate test of business value? In short, the market. Beware of oversimplification though. It does make a big difference how the company is marketed. The selling price for a business presented to a well-funded group of strategic investors is likely to be much higher than even the highest bid at an auction for used equipment.
Are business value and expected selling price the same?
Arguably, the reason to figure out business value is to estimate what it would sell for. That's the theory. In practice, the business value could vary quite a bit depending on who wants to know.
For example, a highly motivated business buyer seeking to replace lost income may pay a premium to get that dream business. A financial buyer is the type who plays the low-cost acquisition game.
Market exposure also plays a role here. Getting the business in front of the right buyers is half the battle in fetching the top selling price. Let the best team take the prize!
Three approaches to business valuation
So far, so good. But what tools are out there to actually measure what a business is worth? In fact, there are three:
- Asset approach
- Market approach
- Income approach
Under the asset approach you adopt the view of a business as a set of assets and liabilities. The balance sheet elements serve as building blocks to create the picture of business value. A finance professor would tell you that the asset approach is based on the economic principle of substitution. It answers this question:
What will it cost to create another business like this one that will produce the same economic benefits for its owners?
The cost here is a bit tricky. Sure, the costs include coming up with the actual business equipment and machinery, office furniture, and the like. But don't forget that costs also include lost income as you are staking out the company's position in the market, while an established competitor is busy raking in the dough.
Plus, you need to account for functional and economic obsolescence of business assets. Things have a tendency to wear out and need to be replaced at some point.
Intangible assets, such as technology, may be getting a bit long in the tooth. A company still using vacuum tubes in its products while the competitors are pushing nanotech is behind the times. Not cool.
So if the company's financial condition is defined by its assets and liabilities, why not just figure out the values of these and calculate business value as the difference, much like on the balance sheet?
The idea is simple enough, but the trick is to figure out which assets and liabilities to include in your valuation and how to measure what each is worth.
If you are thinking the usual accounting balance sheet will do it, think again. Your balance sheet may be missing some crown jewels such as internally developed technology, patents and trademarks, and proprietary ways of doing business.
If the company did not pay for this intellectual property, it does not get recorded on the “cost-basis” balance sheet! Ask your accountant.
But the real value of these assets may be far greater than all the recorded assets put together. Imagine a business without its special products or services that make it unique and bring customers in the door!
Under the market approach, you look for signs from the real market place to figure out what a business is worth. The market is a competitive place, so the economic principle of competition applies:
What are other businesses worth that are similar to my business?
No business operates in a vacuum. If what you do is really great then odds are there are other smart people doing the same or similar things.
Looking to buy a business? You need to decide what type of business you want and then look around to see what the “going rate” is for businesses of this type.
Planning on a business sale? You would do well to check the market to see what similar businesses sell for.
With all this jockeying for the best deal going on, you would think that the market will settle to some sort of business price equilibrium – something the buyers will be willing to shell out and the sellers willing to accept. Enter the fair market value:
The business price that a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, and neither being compelled to close the sale.
In other words, the market approach to business valuation is a great way to determine the company's fair market value – a monetary value exchanged in an arms-length transaction with the buyer and seller each acting in their best interest.
If you know the market, you can support your offer or asking price. After all, if the going rate is this much, why would you offer more or accept less?
The income approach cuts at the core of why people go into business – making money. Unsurprisingly, the economic principle of expectation prevails here:
If I invest time, money and effort into business ownership, what economic benefits and when will it provide me?
Observe the future expectation of economic benefit above. Since the money is not in the bank yet there is a risk you will not see all or part of it when you expect it.
The income valuation approach helps you to figure what kind of money the business is likely to bring as well as to assess the risk.
The real power of the income valuation is that it lets you calculate business value in the present. To do so, the expected income and risk must be translated to today. There are two ways you can do this translation:
Business valuation by income capitalization
In plain English, the capitalization valuation method is essentially the result of dividing the expected business earnings by what is known as the capitalization rate. The idea is that the business value is defined by business earnings and the capitalization rate is used to relate the two.
For example, if the capitalization rate is 33%, then the business is worth about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. Either way, the result is what the business value is today.
The capitalization method works really well for businesses with steady, predictable earnings. Nothing like a cash cow business to cut you a handsome paycheck every month. Life is good.
Valuation of a business by discounting its cash flow
For the rest of us there is the discounting valuation method: first, you forecast the business income some time into the future, usually a number of years. Next, you figure out the discount rate which captures the risk of getting this income on time and in full measure.
Finally, you estimate what the business is likely to be worth at the end of your forecast period. If you expect the company to keep running, there is some residual value, also known as the terminal value. Discounting the forecast earnings and the terminal value together gives you the present value of the business, or what it is worth today.
Business valuation: how discount and cap rates are related
Since both income valuation methods do the same thing, you would expect similar results. You would be right, the capitalization and discount rates are related:
where CR is the capitalization rate, DR is the discount rate, and K is the expected average growth rate in the income stream. As an example, let's say that the discount rate is 25% and your forecast suggests that the business profits would be growing at a steady 5% per year. Then your capitalization rate is 25 - 5 = 20%.
What is the real difference between capitalization and discounting? Capitalization uses a single income figure such as the average of the earnings over several years or the most recent number. The discounting is run on a sequence of income numbers, one for each year in your forecast.
If your business shows smooth, steady profits year after year, the capitalization valuation is a good way to go. For a young start-up or businesses with rapidly changing earnings, discounting gives the most accurate results.
Can business valuation methods produce different results?
You may wonder: is it possible to run income business valuations and come up with different results? You bet. Your assumptions drive the results.
Consider two business buyers doing earnings forecasts and sizing up the risk of owning a given business. Each buyer may see business risk differently so their capitalization and discount rates will differ. In addition, the two buyers may have different ideas of where to take the company. This will affect their income stream projections.
So even if they use the same valuation methods, the business valuation results may differ quite a bit. The financial gurus call it the investment value standard of valuing a business. Each business buyer acts as an investor and measures the business value differently, based on their unique investment goals.
This is great stuff – you have the flexibility of figuring out business value to match your objectives. Income based valuation packs some real punch!
The key takeaway is this: business value is in the eyes of the beholder. It's a good idea to leave no stone unturned by using all three approaches when valuing a business. Explore your business value from every angle.