When you are trying to determine the valuation of a company, one of the most important things that comes into play is the approach. Because business valuations are sought for a wide range of reasons, from selling to divorce to mergers, the approach must be customized to the particular situation. In this piece, we'll take a solid look at different approaches to determining company valuation and in which situations they're typically used.
Different approaches to determining business value
Though asset-based business appraisals may seem like a good route to explore, they're typically only used in liquidation situations, not by healthy businesses planning on managing risk or expanding. Why? Because if you've spent years building your business and establishing a good reputation in your industry and region, you know that your business is worth much more than the sum of its parts. Asset-based approaches only figure the minimum liquidation value of your business assets instead of looking at the value of an established business in the community or the goodwill that it has created. For this reason, we virtually never used asset-based methodology to determine business value.
An income-based approach uses the current value of future income to calculate a business appraisal. It looks at what the income has been in the past and projects it out for a period of years. The most common methods in this approach are capitalization of earnings and discounted earnings, also referred to as discounted cash flow.
- Capitalization of earnings takes into account the business earnings and is mainly used when results are steady.
- Discounted cash flow looks at the expected future business earnings putting more weight in near years versus out years.
By comparison, the market-based approach looks at substitution. The appraiser looks at how much similar businesses have sold for, then adjusts the sale price on the differences between your business and the ones being analyzed. Because the businesses have things in common being in related industries, it is a good method to see what actual acquirers pay. The most commonly-used methods are as follows:
- Guideline public company looks at a similar public company compared to your private company. If you are valuing a small business, this might not be the best way to compare entities.
- Guideline company transactions take similar companies with similar transaction levels and then adjust for any differences. The transactions are then applied against a multiple to determine the value of the company. Databases provide details of small business transactions.
- Multiple of discretionary earnings looks at similar companies and what kind of discretionary earnings they make, then adjusts it to the company being appraised to determine business value.
- Gross revenue multiple looks at the gross revenue of similar companies and adjusts it to the company under appraisal, then uses a multiplier to determine value.
By knowing the different approaches, you gain a better understanding of how valuations work and why your appraiser is selecting a particular method.