A business valuation is a value verified through statistical and factual analysis used to determine what a business is worth. Understanding your business valuation and making sure it is accurate requires a good amount of preparation and research. A business’s value is the expected or calculated price that a business at its current state would sell for in the market. Companies should always be aware of their valuation regardless if they are planning on selling off their assets any time soon. There are three methods or approaches to business valuation. Each approach is different in the way that they tackle valuing the business. The three approaches to valuing a business are the asset approach, the market value approach and the income based approach. It is important to update a company’s business valuation on a regular basis to ensure the valuation is current and accurate. (Kasanoff, 10/13/15)
The asset based approach of a business valuation, also known as the cost approach (or the replacement cost approach) values each component of the business separately. Asset values are totaled and the liabilities are subtracted to derive the total value of the enterprise. The asset approach determines the business’s value based on the value of its assets. This value determines the cost to recreate the business. The asset-based approach bases the valuation on the fair market value of the company’s assets less its liabilities. One of the most commonly used methods under the asset based approach is known as the Adjusted Net Asset Method. This method of valuation is balance-sheet focused and values a company using the difference between the fair market value of a company’s assets and liabilities. Professional appraisers take a look at the company’s historical balance sheet and make adjustments to each asset and liability item at its fair market value, or the agreed-upon price by the buyer and seller. Adjustments are made to the company’s historical balance sheet in order to present each asset and liability item at its respective fair market value. (Trugman, 2014)
The market value approach of a business valuation is the most fundamental approach in a fair market value appraisal. This approach emphasizes the principle of substitution. The market value approach establishes the business value through historic sales comparables of companies in similar industries. This method relies on pricing multiples, which attempt to determine the relationship between a company’s fiscal performance and its expected sale price. Sales of firms in the same industry help to give buyers a good scope on the business being valued. The market value approach is the most direct approach for establishing the fair market value of a business. It helps take a holistic look at one’s business and make decisions that are highly impactful for all stakeholders. This approach gives managers the opportunity to understand the subtle dynamics of their business and avoid potential unforeseen consequences of seemingly reasonable decisions. A value-based approach will help to set one’s firm apart from competition and noticeably change the way the market views the company. (Trugman, 2014)
The income based approach to a business valuation focuses on the main reason for running a business, obtaining revenues and profits. This approach determines the value of a business on its capability to produce and maintain desired economic benefit for its shareholders. The main intention of the income based approach to a business valuation is to determine the firm’s value as a function of the economic benefit. The economic benefit such as the seller’s discretionary cash flow or net cash flow is capitalized, discounted or multiplied to perform the valuation. (Trugman, 2014) Warren Buffett uses a discountedcash-flow analysis to value his company, Berkshire Hathaway. He looks at the amount of cash generated each year, projects it into the future and then calculates the worth of that “discounted” cash flow stream using the long-term Treasury bill interest rate. To properly utilize the income based approach of business valuation, companies must select an accurate and representable capitalization rate and discount rate, while also locating credible valuation multiples.
Companies need to keep their business valuations current and up-to-date on a regular basis. Valuation can be used to analyze current and expected debt, for raising capital or equity, or for when a company feels its best course of action would be to execute a merger. Specifically, if you are selling your business, knowing your valuation is extremely important. However, the valuation of your company can and should be used as a resource of how to manage one’s business. Knowing your value helps to track the effectiveness of your strategic-decision making process as well as aiding to provide executives with the ability to track performance in terms of change in value. Understanding the valuation of your business gives you a verifiable advantage over the competition. To obtain a business valuation, business owners can contract with an appraiser to provide a specific opinion that will be viewed as independent and objective with the IRS. This valuation then may be used in an assortment of planning applications. It could be used to authorize the owner to sell the business at a higher sales price, or for the business owner or his heirs to pay less in taxes after the sale of the business or the death of the owner.
Regardless of the cost or methods of a business valuation, it is important for the process to be conducted as objectively as possible by a qualified licensed appraiser. For this reason, many companies use a third party to conduct their business valuation. This eliminates all potential liability from the company.Additionally, this estimated value of the business may be useful data for the owner in putting together a succession, estate or personal retirement plan. In the worst case, not knowing fair market value could cause owners to potentially sell their businesses for less than they actually are worth (or for their heirs to possibly pay more than their share of estate taxes after the owner’s death). For these reasons, the cost of a business valuation can be an excellent investment.
Although valuations are excellent tools to give buyers and sellers a benchmark for the total value of the enterprise, each valuation has a short half-life. Sales can go up or down. Demand can take a dive which could cause your company to move to produce less. The economy could take a downturn. Some M&A firms recommend soliciting an appraiser to give a professional valuation even before the process of selling one’s company begins. Many companies get their valuations before they meet with bankers to conduct targeted or even broad sell-side deals. In their view, it provides the business owner with a benchmark or baseline to use in negotiating a sale. For these reasons, it is important to keep your company’s valuation up to date and on-hand at all times. Knowing your business valuation is one thing, but making sure it is as accurate as possible is just as important. But, in some cases, buyers won’t take a business’s valuation into much consideration. Buyers will go in and conduct an evaluation on their own with their own set of conditions, criteria, and the results of their extensive due diligence. Although buyers are very interested in the company’s balance sheet and other consolidated reports, they’re also interested in the synergy created and advantage they can utilize if they end up purchasing the business. A professional valuation simply can’t take these characteristics into account. (Lonsdale, 8/6/12)
A valuation can be very useful when there is a specific reason for it and a time frame within which to use it. But the state of a company can change pretty quickly. All in all, it is essential to keep an updated valuation of your business on hand at all times, as a precautionary measure.
– Lonsdale, David. (8/6/12). Why a Valuation is Less Important Than You Think. (http://www.inc.com/david- lonsdale/why-a-valuation-is-less-important-than-you-think.html)
– Valuadder. Business Valuation: The Three Approaches. (http://www.valuadder.com/valuationguide/business-valuation-three-approaches.html)
– Kasanoff, Bruce. (10/13/15). Forbes. Most Companies Don’t Know What They Are Selling.
– (https://www.forbes.com/sites/brucekasanoff/2015/10/13/most-companies-dont-know-what-they-are- selling/#7e6787235342)
– Trugman, Linda B. (2014). Business Valuation Approaches. Business Valuation Fundamentals for the Non- Valuation Expert. (http://trugmanvaluation.com/valuation/wp-content/uploads/sites/2/2015/01/Business- Valuation-Fundamentals_2014.pdf)