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.
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.
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:
By knowing the different approaches, you gain a better understanding of how valuations work and why your appraiser is selecting a particular method.