It is interesting to us how poorly understood business valuation processes are to business owners who, in turn, are the very folks who need to better understand what their businesses are worth. Knowing the value of a business is important for owners who need that information to strategize for the future, bring in new owners, buy-out departing owners, or to react to buyout offers.
A few caveats. In truth, the marketplace gives the most accurate business value (a business is “really” only worth what another is willing to pay for it). Secondly, there is a lot of subjectivity that goes into valuations. Two different appraisers can interpret the opportunities and risks associated with a given company in different (but equally logical) ways which, in turn, result in different valuations (this is also very true with Wall Street analysts who project stock prices).
There are three ways that a valuation analyst approaches a business appraisal. The first is the Asset Approach. As the name implies, this approach focuses mostly on a company’s balance sheet. The analysis comes about when the analyst examines the assets and liabilities and, where applicable, make updates to approximate current values. This is important because the stated book value, which is derived from cost-accounting figures, isn’t an accurate reflection of current fair market value. Once the assets and liabilities have been updated to current values, the difference is the updated book value which constitutes the asset-based valuation.
We find that the Asset approach is most effective when a company has a large number of identifiable assets like land, minerals, large machinery, etc. This approach is less effective when a company is more service-based and/or has large amounts of intangible assets like owner goodwill.
Another method is the Market approach which is accomplished by comparing the subject company to public company valuations and/or actual market transactions involving entire firms. Usually, this is done by applying different multiples (of sales and profits) exhibited by the public/private guideline companies… to the subject firm. Extreme care must be taken to ensure that there is a high degree of comparability between the firms being analyzed (services or products offered, size and profitability, accounting methods, type of transaction, etc.). If a suitable level of comparability can be achieved, then the Market Approach method is often the most “satisfying” valuation approach.
Lastly, analysts use the Income method which is often regarded as the most intellectually sound of the three approaches. In this case, the analyst projects the cash flows of the subject company into the future…and then uses a discount rate to assess the value of those cash flows. The challenge here is twofold. The analyst must take care to construct a fairly accurate forecast, taking into account the given firm’s strengths and weaknesses, as well as the challenges and opportunities in the market. Then, the discount rate must be as reasonable as possible, considering inputs like the current risk-free rate, as well as various risk adjustments to reflect general equity ownership, the industry type, the relative company size… and company-specific factors. The amount (and cost) of leverage should also be considered.