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Business valuation: what are the common methodologies used to value a small business?
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There are generally three approaches to valuing a privately-held business: 1. Asset
Approach; 2. Market Approach; and 3. Income Approach. Various methods can be used under each approach, depending on the nature of the business and the availability of external data.
The asset approach is usually the least relevant, because, as its name implies, the subject company's value is based on the sum of the values of the assets (net of liabilities) on the company's balance sheet. This approach is least relevant in most cases (unless the company is a bank, where its assets are its business), because it doesn't account for the value of the subject company's cash flows, which are often the largest component of value. Because the balance sheet is used to determine value, the asset approach is most often used for companies in liquidation.
When using the market approach, the analyst identifies certain market transactions to derive ratios, or multiples, of elements such as revenues, earnings, and EBITDA, which are then applied to the subject company to determine value. Market transactions could be public companies or privately held companies similar to the subject. The analyst applies the multiples of the comparable companies to the revenues, earnings, or EBITDA of the subject company. The resulting values are then adjusted to account for differences between the comparable companies and the subject company. Such differences may include size, risk, or, in the case of public company comparable transactions, the lack of marketability of the stock of the subject company.
The income approach uses a normalized measure of the future earnings of the subject company, most often cash flows, then discounts, or capitalizes, that stream of cash flows at a rate most often based on the weighted average cost of capital (WACC). Various factors are used to determine WACC, including the cost of debt and equity financing, and premiums for size and various risk factors. Since value is determined by dividing cash flows by the discount rate, as this rate increases, the resulting valuation decreases. This method is referred to as the discounted cash flow method.
The foregoing description is somewhat oversimplified for the sake of brevity. In practice, there are other methods of valuation available and countless other factors are included in the analysis. Although a good valuation will use and emphasize the most relevant valuation method, it will also include other methods and the values derived from those methods as a "sanity check" and to provide support for the ultimate value determination.
A reasonable value range can be established using a combination of commonly used valuation approaches:
Valuation Methods
■Income approach. This analysis assumes that the buyer is looking at a business as an investment and primarily interested in ROI (return on investment). The businesses value is derived by capitalizing some level of earnings using a cap rate, discount rate or multiplier. This method relies on future projections and growth rates to decide what the business may be worth.
■Asset-based approach. This method adjusts the assets from their reported book value to their in-place market value utilizing cost and market data to derive the business value. It uses tangible assets such as furniture and equipment, and intangible assets such as trademarks, copyrights and patents. For the most part the asset approach does not properly represent the value of an ongoing business that has positive earnings.
■Market Approach. This method produces a value using comparative ratios derived from past transactions of privately-held and/or publicly-held companies, and rules of thumb. Each industry has rules of thumb formulas that may be used as a guide in combination with other techniques. This method can be very reliable in most cases and is a strong indicator of value.
Since profits on financial statements and tax returns of most privately-held businesses are usually minimized in order to reduce income taxes, the financial statements must be recast in a valuation to show the true monetary benefits of owning the business.
Typically, a review of the last three (3) to five (5) years of business financials and recasting them to reflect the discretionary earnings of the business. In addition, an in-depth interview with the owner would be in order to understand the strengths and weaknesses of the business as well as the value drivers that it may contain.
Some factors, or value drivers, that will be taken into consideration in determining the business value will include growth potential, competition, regional and industry demand, proprietary products or processes, favorable lease terms, advantageous supplier relationships, quality of workforce and management, concentration of customers, terms of payment for the acquisition, the type of buyer the business would bring, and current economic conditions, to name a few.
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