Although professional business brokers and appraisers utilize a vast variety of valuation methods, some are certainly better than others depending on your exact situation. That being stated, there are four standard methods that are most widely used across all types of businesses and industries alike. In essence, they are considered to be the standards in the realm of business valuation methods. It is a good idea for both buyers and sellers to be familiar with all four.
1. The Asset-Based Business Valuation Method
Basically speaking, the asset-based business valuation methods are utilized in order to calculate or total up all the investments in a particular business. The asset-based valuations can be performed on either a going concern or on a liquidation basis. In essence, the asset approaches place a fair market value on what a business actually owns. This includes equipment, real estate, patents, or digital accounts such as specific URLs. Anything that a business can turn around and sell in as-is condition is generally considered an asset. There are actually two common methods of valuing a business based on its assets. They are as follows.
- The Asset Accumulation Approach
For this method, an organization compiles a list of all of its tangible and intangible assets and compares them directly to all of the company's liabilities. The difference is considered to be the business's assets. In essence, it is the amount of money that would be leftover if a company sold off all of its equipment, intellectual property, and real estate/physical location. This method is also referred to as the liquidation asset-based approach. The bottom line is that it determines the nest cash that would be received if all assets were sold and the liabilities are paid off in full.
- The Capitalized Excess Earnings Approach
This asset valuation method adds together the value of the tangible business assets with excess earnings. In essence, the excess earnings are considered to be the business earnings that are not derived from tangible assets. This method is also referred to as a going concern asset-based approach, which lists the company's net balance sheet value of its assets and then subtracts the value of its liabilities.
Utilizing the asset-based approaches to value a sole proprietorship is a bit more difficult. In a corporation, all of the assets are owned by the business and are typically included in the sale of the business. On the other hand, the assets in a sole proprietorship are in the name of the current business owner. Separating the assets from business and personal use can be tricky to say the least. For example, a sole proprietor in a home improvement business may use various pieces of equipment for both business use and personal use. The potential buyer of the company will need to differentiate the assets that the owner intends to keep or sell as part of the business.
2. The Earning Value-Based Business Valuation Method
Earning value methods are based on the basic principle that an organization's ultimate value is in its ability to produce future earnings and its capacity to accumulate wealth. One of the most common types of earning value approaches is known as the capitalizing of past earnings method. This method involves a valuator who determines a level of expected cash flow that is based on a company's prior earnings. This information is then normalized for unusual expenses or revenue and multiplied by a capitalization factor. This capitalization factor can tell you what rate of return the average buyer would expect on the investment, in addition to the level of risk.
Another type of earning value approach is called discounted future earnings. This method determines an average of the trend of potential earnings in the future instead of an average of past earnings. The average is then divided by the capitalization factor. It is important to note that the valuation of any type of sole proprietorship in relation to prior earnings can be challenging, as loyalty from customers often comes with an association with the business owner. Existing customers often expect the new owner to deliver the same quality of products or services than the previous owner.
3. The Market Value-Based Business Valuation Method
In the market value approach, the value of a company is established by comparing the business to other similar businesses that have recently sold.
While this method can be rather useful, there has to be an ample number of similar businesses sold in order to obtain great results. It can be especially difficult to assign a value to a sole proprietorship as they are individually owned and locating public information on past sales is not always easy. In today's day and age, the earning value method is no doubt one of the most popular business valuation methods.
That being stated, the vast majority of businesses find success when combining this method with other business valuation approaches. In fact, professional business appraisals often include different market valuation methods, such as the comparative transaction method and the guideline publicly traded company method. Each of these valuation methods requires the comparison of the subject business to other businesses sold recently in the same or a similar industry.
For privately owned firms, transactions that involve small capitalization public companies are generally used as evidence of business value. Determining the fair market value of a business typically requires the utilization of valuation firms that are derived from comparable business sales. If non-competition clauses are involved in the agreements for a sale of a business, know that these can affect valuation.
4. The Return On Investment Based Business Valuation Method
The return on investment, or ROI method for short, is a rather quick and easy way for both buyers and sellers to calculate the value of a business. That being stated, it should only be utilized for initial conversations. The methods listed above are far more accurate and detailed when it comes down to actual negotiations regarding the actual sales price. However, the ROI method does answer a primary concern. When you are considering investing in something, it is important to have a grasp on your return on that investment.
For example, if you purchase a stock in a publicly-traded company you certainly want a return, but what is considered a good return? It ultimately depends on the market, which is why business valuation, in general, can be so subjective. In order to see the ROI-based method in action, let's take a look at the television show "The Profit." Believe it or not, you can actually learn a great deal about business valuation from watching this show. That is if you are paying careful attention. One of the main discussions that the host of the show has with the business owners is how much money he is willing to invest for a particular percentage of ownership in their companies.
In essence, he is putting a value on the business at this point. The math is actually rather simple when calculating the value of a business based on the ROI method. Simply divide the amount of money desired by the percentage offered. It equals a business evaluation of 100%. For example, you are buying a business and offer $500,000 for 50% of the business. That means you are valuing the business at $1,000,000. The bottom line here is that you have just performed a business valuation right on the spot.
However, as mentioned above, you may want to back these numbers by utilizing the other three (3) business valuation methods. If you are utilizing the ROI approach in order to seek buyers, you will absolutely need to convince them of the valuation in order to even start an initial conversation. You can begin by having answers to the following questions.
- How long will it take to recover my original investment?
- After that, when I look at my share of the expected net income, compared with my investment, what does my return look like?
- Is that number realistic? Ambitious? Conservative?
- Does it make me want to invest in this company?
The answers to all of these questions will help to provide a far more accurate ROI-based business valuation.