Business Valuation Blog | Understanding Buying / Selling a Company

When accredited/certified appraisers value businesses, equipment, and personal property, they are taught to consider and ultimately rely on a consistent set of approaches and methodologies, regardless of the industry or type of asset being appraised. This fundamental component of professional valuation principles may be the most important topic to understand in the valuation field. Without this set of guidelines, appraisers could essentially do whatever they wanted in support of reaching their conclusions, which would lead to an unregulated industry that could not be properly governed by the organizations that oversee it.

That being said, the particular types of property being appraised, along with the markets and industries in which they operate, will dictate their own set of variables that will influence value under these fixed approaches and methodologies. Depending on the overall scope of work and available data, they may also lead the appraiser down a certain path of relying on specific approaches over others.

For example, in business valuation, the multiples and risk premiums relied upon under the market and income approaches may vary considerably depending on the specific company and industry involved.

Another example in machinery and equipment appraisal is that the available market data for new and used equipment will dictate how much weight can be placed on the cost and sales comparison approaches. The useful life and effective age of a particular asset will also affect its value.

These distinct variables will influence value within each market and industry; however, the appraiser needs to stay within the lanes of the acceptable approaches they are taught to consider and rely upon.

It’s perfectly acceptable to exclude certain approaches if the data isn’t there to support them or the situation doesn’t call for it. For example, the income approach is rarely used when appraising machinery and equipment, however, it is one of the more common methods when valuing businesses as a whole. This is due in part to the difficulty of tying revenue and expenses directly to the underlying tangible assets of a business.

The premise of value being considered will also factor into the equation. If a company and its underlying assets are being liquidated and are no longer a going concern, then the approaches and methodologies relied upon will be different.

In summary, every valuation project will have its own distinct components within it, however, the appraiser must consider the same set of accepted approaches regardless of the situation.

Business owners likely have particular ideas about the value of their company and how best to calculate it, given their experience and knowledge of their financial history, and understanding of the market and industry in which they operate. When you need to formally engage an experienced, certified business appraiser to value your company, it's important to understand the standard accepted approaches they consider and weigh during the process.

There are three approaches to business valuation, namely the Income Approach, the Market Approach, and the Asset Approach. Each of these methodologies can be broken down further and considered based on the type of business you own, available data to analyze, and the company’s current operational status. Here is a brief summary:

The income-based approach has two primary methods that take into account whether the business income is steady or inconsistent. Essentially, the company's income is measured over a period of time to determine its overall value. Under a “Capitalization of Earnings” approach, the appraiser will consider both historic and future income probability, based on a steady stream of revenue, and discount these streams to realize a net present value, while using appropriate rates of capitalization.

Under the “Discounted Future Earnings” approach, the appraiser will estimate value primarily from future income probability, or forecasts, over a fixed period of time, to a terminal value, and discount this back to the present

Market Approach

>The Market Approach determines business value where the subject company being appraised can be compared to available businesses traded in the public marketplace. Adjustments are made to better match the private business based on revenue and overall size.

These guidelines are either investor-driven or transactional, depending on the data available. For example, a similar publicly-traded company may have available the price investors paid for minority interests in that company. This can then be adjusted to match the subject private business profile.

Other methods which take components of both the income and market approach are the “Multiple of Discretionary Earnings” and “Gross Revenue Multiple” which consider the actual income of the business being appraised and apply a market-derived multiple to these earnings based on available public data.

Asset Approach

As a general rule, the asset approach is considered and primarily weighed when a business is operating at a loss or has shut down temporarily or permanently. The options available to the appraiser under this approach are as follows:

Adjusted Net Asset Value: Under this methodology, the appraiser will adjust the company's tangible assets based on an estimate of Fair Market Value, while taking into account existing liabilities.

Liquidation Value: If the business has permanently ceased operations, and a compulsion to sell the remaining assets is the only remaining option, the value of the assets is measured under an Orderly or Forced Liquidation premise.

Book Value: This method relies solely on the net book figures of the assets recorded on the company’s books, without adjusting to market or liquidation value. Given accounting depreciation methods are usually accelerated, this will likely lead to undervaluing the assets.

Excess Earnings: This method takes into account the historic earnings of the company and provides a broad way to measure intangible asset value as well as tangible, by estimating the goodwill of a business along with personal property, equipment, improvements buildings, and land. This is generally preferred for fully operational companies with a lot of tangible assets.

By gaining a better understanding of these valuation methods, you will be able to work together with your certified, experienced business appraiser, in a successful fashion, to properly appraise your company.