What is Business Valuation?
Quite simply, business valuation is a process and a set of procedures used to
determine what a business is worth. While this sounds easy enough, getting your
business valuation done right takes preparation and thought.
For one thing, there is no one way to establish what a business is worth. That's
because business value means different things to different people. A business
owner may believe that the business connection to the community it serves is
worth a lot. An investor may think that the business value is entirely defined by its
historic income.
In addition, economic conditions affect what people believe a business is worth. For
instance, when jobs are scarce, more business buyers enter the market and
increased competition results in higher business selling prices.
The circumstances of a business sale also affect the business value. There is a big
difference between a business that is shown as part of a well-planned marketing
effort to attract many interested buyers and a quick sale of business assets at an
auction.
Hence, business value is really an expected price the business would sell for. The
real price may vary quite a bit depending on who determines the business value.
Compare a buyer who wants the business now because it fits important lifestyle
goals to a buyer that purchases an income stream at the lowest price possible. The
selling price also depends on how the business sale is handled. Contrast a wellconducted business marketing campaign and a "fire sale".
Three valuation approaches
That said, there are three fundamental ways to measure what a business is worth:

Asset approach.

Market approach.

Income approach.
Asset approach
The asset approach views the business as a set of assets and liabilities that are
used as building blocks to construct the picture of business value. The asset
approach is based on the so-called economic principle of substitution which
addresses this question:
What will it cost to create another business like this one that will produce
the same economic benefits for its owners?
Since every operating business has assets and liabilities, a natural way to address
this question is to determine the value of these assets and liabilities. The difference
is the business value. Sounds simple enough, but the challenge is in the details:
figuring out what assets and liabilities to include in the valuation, choosing a
standard of measuring their value, and then actually determining what each asset
and liability is worth.
For example, many business balance sheets may not include the most important
business assets such as internally developed products and proprietary ways of
doing business. If the business owner did not pay for them, they don't get recorded
on the "cost-basis" balance sheet! But the real value of such assets may be far
greater than all the "recorded" assets combined. Imagine a business without its
special products or services that make it unique and bring customers in the door!
Market approach
The market approach, as the name implies, relies on signs from the real market
place to determine what a business is worth. Here, the so-called economic principle
of competition applies:
What are other businesses worth that are similar to my business?
No business operates in a vacuum. If what you do is really great then chances are
there are others doing the same or similar things. If you are looking to buy a
business, you decide what type of business you are interested in and then look
around to see what the "going rate" is for businesses of this type. If you are
planning to sell your business, you will check the market to see what similar
businesses sell for. It is intuitive to think that the "market" will settle to some idea
of business price equilibrium - something that the buyers will be willing to pay and
the sellers willing to accept. That's what is known as the fair market value:
The business price that a willing buyer will pay, and a willing seller will accept for
the business. Both parties are assumed to act in full knowledge of all the relevant
facts, and neither being under compulsion to conclude the sale.
So the market approach to valuing a business is a great way to determine its fair
market value - a monetary value likely to be exchanged in an arms-length
transaction, when the buyer and seller act in their best interest. Market data is
great if you need to support your offer or asking price - after all, if the "going rate"
is this much, why would you offer more or accept less?
Income approach
The income approach takes a look at the core reason for running a business making money. Here the so-called economic principle of expectation applies:
If I invest time, money and effort into business ownership, what economic
benefits and when will it provide me?
Notice the future expectation of economic benefit in the above sentence. Since the
money is not in the bank yet, there is some measure of risk - of not receiving all or
part of it when you expect it. So, in addition to figuring out what kind of money the
business is likely to bring, the income valuation approach also factors in the risk.
Since the business value must be established in the present, the expected income
and risk must be translated to today. The income approach uses two ways to do
this translation:

Capitalization

Discounting
In its simplest form, the capitalization method basically divides the business
expected earnings by the so-called capitalization rate. The idea is that the business
value is defined by the business earnings and the capitalization rate is used to
relate the two. For example, if the capitalization rate is 33%, then the business is
worth about 3 times its annual earnings. An alternative is a capitalization factor
that is used to multiply the income. Either way, the result is what the business
value is today.
The discounting method works a bit differently: first, you project the business
income stream over some future period of time, usually measured in years. Next,
you determine the discount rate which reflects the risk of getting this income on
time. Last, you figure out what the business will be worth at the end of the
projection period. This is called the residual or terminal business value. Finally, the
discounting calculation gives you the so-called present value of the business, or
what it is worth today.
Since both income valuation methods do the same thing, you would expect similar
results. If fact, the capitalization and discount rates are related:
CR = DR - K
where CR is the capitalization rate, DR is the discount rate, and K is the expected
average growth rate in the income stream. Let's say that the discount rate is 25%
and your projections show that the business profits are growing at a steady 5% per
year. Then the capitalization rate is 25 - 5 = 20%.
Perhaps the biggest difference between capitalization and discounting is what
income input you use. Capitalization uses a single income measure such as the
average of the earnings over several years. The discounting is done on a set of
income values, one for each year in the projection period. If your business shows
smooth, steady profits year to year, the capitalization method is a good choice. For
a growing business with rapidly changing and less predictable profits, discounting
gives the most accurate results.
Is it possible to use the income business valuation methods and arrive at different
results? Yes indeed! Consider two prospective business buyers doing the income
projections and assessing the risk of owning a given business. Each buyer will likely
have a different perception of the risk involved, hence their capitalization and
discount rates will differ. Also, the two buyers may have different plans for the
business, which will affect how they project the income stream.
Thus, even if they use the same valuation methods the resulting value conclusions
may be quite different. Put another way, the two buyers apply the so-called
investment value standard to determine the business worth. They measure the
business value differently, based on their unique ownership or investment
objectives. This flexibility of measuring the business worth to match one's
objectives is one of the greatest strengths of the income valuation approach.
Five steps to establish your business worth
Business valuation is a process that follows a number of key steps starting with the
definition of the task at hand and leading to the business value conclusion. The five
steps are:
1. Planning and preparation
2. Adjusting the financial statements
3. Choosing the business valuation methods
4. Applying the selected valuation methods
5. Reaching the business value conclusion
Let's examine in more detail what happens at each step.
Step 1: Planning and preparation
Just as running a successful business takes planning and disciplined effort, effective
business valuation requires organization and attention to detail. The two key
starting points toward establishing your business worth are:

determining why you need business valuation

assembling all the required information.
It may seem surprising at first that the valuation results are influenced by your
need for business valuation. Isn't business value absolute? Not really. Business
valuation is a process of measuring business worth. And this process depends on
two key elements: how you measure business value and under what circumstances.
In formal terms, these elements are known as the standard of value and the
premise of value.
Business value depends on how and why it's measured
A few examples will illustrate this important point.
Let's say you want to sell your business. Business has been good, with revenues
and profits growing each year. You plan to market the business until a suitable
buyer is found. You want to pick the best offer and are not in a hurry to sell. In this
situation your standard of value is the so-called fair market value. Your premise of
value is a business sale of 100% ownership interest, on a going concern basis. In
other words, you plan to sell your business to the highest and most suited bidder
and it will continue running under the new ownership.
Next let's imagine that you own a small business that has developed a product of
great interest to a large public corporation. They already approached you offering
to buy you out. They have some great plans for your product and want to sell it
internationally. These people are even prepared to offer you some of their publicly
traded stock. As your CPA tells you this can significantly lower your taxable gain on
the business sale.
In this scenario you have a synergistic buyer who is applying the so-called
investment standard of measuring your business value. Such buyers are often
willing to pay a premium for a business because they can realize some unique
advantages through a business purchase.
Now consider a situation where the business owners need to settle a large bill with
one of the business' creditors who is tired of waiting. There is not enough cash in
the bank to cover the amount, so business assets need to be sold quickly. This is
the case where the so-called forced liquidation premise of value may apply business owners don't have enough time to look for a suitable buyer and may have
to resort to a quick auction sale.
Once you know how and under what conditions you will measure your business
worth, it is time to gather the relevant data that impacts the business value. This
data may include the business financial statements, operational procedures,
marketing and business plans, customer and vendor information, and staff records.
Business facts affect business value
Here are a few examples of how information about the quality of operation affects
the business value.
Well-documented financial statements and tax returns are essential to demonstrate
the business earning power. Steady, above industry norm earnings tend to
translate into higher business value.
Detailed written business operating procedures make it easy to understand how the
business works, who does what, and what skills are required. Since it is easier to
take over a well-organized business, there is higher business buyer interest and
competition among them tends to increase the business selling price.
A good marketing plan provides the essential inputs into the future business
earnings projections. And accurate earnings projections are key to establishing the
business value based on its income.
A look at the customer list quickly shows where the business gets its revenues.
Businesses that do not rely on a few large customers for most of their business
sales tend to command a higher selling price.
Let's say that the business enjoys an exclusive distribution agreement with a major
vendor, a key competitive advantage. If this agreement can be transferred to the
business buyer, the business selling price is likely to be higher.
Skilled and motivated staff is essential to business success. Not surprisingly, if
experienced long-term employees stay with the business after the sale, the selling
price is likely to reflect it.
Some of the information will provide immediate and useful parameters to determine
the business value. Other parts of this data, notably the company's historical
financial statements, require adjustments to prepare inputs for the business
valuation methods. We discuss the financial statements adjustment process in the
following sections.
Step 2: Adjusting the historical financial statements
Business valuation is largely an economic analysis exercise. Not surprisingly, the
company financial information provides key inputs into the process. The two main
financial statements you need for business valuation are the income statement and
the balance sheet. To do a proper job of valuing a small business, you should have
3-5 years of historic income statements and balance sheets available.
Many small business owners manage their businesses to reduce taxable income. Yet
when it comes to valuing the business, an accurate demonstration of the full
business earning potential is essential. Since business owners have considerable
discretion in how they use the business assets as well as what income and
expenses they recognize, the company historical financial statements may need to
be recast or adjusted.
The idea is to construct an accurate relationship between the required business
assets, expenses and the levels of business income these assets are capable of
producing. In general, both the balance sheet and the income statement require
recasting in order to generate inputs for use in business valuation. Here are the
most common adjustments:

Recasting the Income Statement.

Recasting the Balance Sheet.
Step 3: Choosing the business valuation methods
Once your data is prepared, it is time to choose the business valuation procedures.
Since there are a number of well-established methods to determine business value,
it is a good idea to use several of them to cross-check your results.
All known business valuation methods fall under one or more of these fundamental
approaches:

Asset approach

Market approach

Income approach
The set of methods you choose to determine your business value depends upon a
number of factors. Here are some key points to consider:

The complexity and value of the company's asset base.

Availability of the comparative business sale data from the market.

Business earnings history.

Availability of reliable business earnings projections into the future.

Availability of data on the business cost of capital, both debt and equity.
Choosing the asset based business valuation methods
Determining the value of an asset-rich company may justify the cost and
complexity of the asset-based valuation methods, such as the asset accumulation
method. In addition to valuing the individual business assets and liabilities, the
method can be helpful when allocating the business purchase price across the
individual business assets, as part of the asset purchase agreement. However, the
method requires considerable skill in individual asset and liability valuation which
often makes its application costly and time consuming.
How the market based business valuation methods work
Market based business valuation methods focus on estimating business value by
examining the business sale transaction data available from the actual market
place. There are two types of transaction data that can be used:

Guideline transactions involving similar public companies.

Comparative transactions involving private companies that closely resemble
the subject business.
The advantage of using the public guideline company data is that it is plentiful and
readily available. However, you need to be careful when selecting such data to
make an "apples to apples" comparison to a private company. In contrast,
reviewing business sales of similar private companies provides an excellent and
direct way to estimate the business value. The challenge is gathering sufficient data
for a meaningful comparison.
Regardless of which market-based method you choose, the calculations rely on a
set of so-called pricing multiples that let you estimate the business worth in
comparison to some measure of the business economic performance. Typical
pricing multiples used in small business valuation include:

Selling price to revenue.

Selling price to business earnings such as net income, Seller’s Discretionary
Cash Flow, EBITDA, or net cash flow.
Each pricing multiple is a ratio of the likely business selling price divided by the
respective economic performance value. So, for instance, the selling price to
revenue multiple is calculated by dividing the business selling price by business
revenue.
To estimate your business value, you can use one or more of these pricing
multiples. For example, take the selling price to revenue pricing multiple and
multiply it by the business annual revenue. The result is the business selling price
estimate.
More sophisticated market based business valuation methods use business pricing
rules that make an intelligent choice of which pricing multiplies to apply when
valuing a business. In addition, these methods account for key business attributes
automatically:

Business revenue or profits

Inventory

Furniture, Fixtures, & Equipment

Tangible asset base
The income based business valuation
Income based business valuation methods determine business worth based on the
business earning power. Business valuation experts widely consider these methods
to be the most accurate. All income-based business valuation methods rely on
either discounting or capitalization of some measure of business earnings.
The discounting methods, such as Discounted Cash Flow, produce very accurate
results by letting you specify the details of the expected business income stream
over time. The Discounted Cash Flow method is an excellent choice for valuing a
young or rapidly growing company whose earnings vary considerably.
Alternatively, the so-called direct capitalization methods, such as Multiple of
Discretionary Earnings, determine your business worth based on the business
earnings and a carefully constructed capitalization rate. The Multiple of
Discretionary Earnings method is an outstanding choice for valuing small
established companies with consistent earnings and growth rates.
Step 4: Number crunching: applying the selected business
valuation methods
With the relevant data assembled and your choices of the business valuation
methods made, calculating your business value should produce accurate and easily
justifiable results.
One reason to use several business valuation methods is to cross-check your
assumptions. For example, if one business valuation method produces surprisingly
different results, you could review the inputs and consider if anything has been
overlooked.
Step 5: Reaching the business value conclusion
Finally, with the results from the selected valuation methods available, you can
make the decision of what the business is worth. This is called the business value
synthesis. Since no one valuation method provides the definitive answer, you may
decide to use several results from the various methods to form your opinion of what
the business is worth.
Since the various business valuation methods you have chosen may produce
somewhat different results, concluding the business value requires that these
differences be reconciled. Business valuation experts generally use a weighting
scheme to derive the business value conclusion. The weights assigned to the results
of the business valuation methods reflect their relative importance in reaching the
business value estimate.
Here is an example of using such a weighting scheme:
Approach
Valuation Method
Value
Weight Weighted Value
Market
Comparative business sales
$1,000,000 25%
$250,000
Income
Discounted Cash Flow
$1,200,000 25%
$300,000
Income
Multiple of Discretionary Earnings $1,350,000 30%
$405,000
Asset
Asset Accumulation
$190,000
$950,000
20%
The business value is just the sum of the weighted values which in this case equals
$1,145,000.
While there are no hard and fast rules to determine the weights, many business
valuation experts use a number of guidelines when selecting the weights for their
business value conclusion:
The Discounted Cash Flow method results are weighted heavier in the following
situations:

Reliable business earnings projections exist.

Future business income is expected to differ substantially from the past.

Business has a high intangible asset base, such as internally developed
products and services.

100% of the business ownership interest is being valued.
The Multiple of Discretionary Earnings method gets higher weights when:

Business income prospects are consistent with past performance.

Income growth rate forecast is thought reliable.
Market based valuation results are weighted heavier whenever:

Relevant comparative business sale data is available.

Minority (non-controlling) business ownership interest is being valued.

Selling price justification is very important.
The asset based valuation results are emphasized in the weighting scheme when:

Business is exceptionally asset-rich.

Detailed business asset value data is available.
Market Business Valuation Methods
Market-based business valuation methods are routinely used by business owners,
buyers and their professional advisors to determine the business worth. This is
especially so when a business sale transaction is planned. After all, if you plan to
buy or sell your business, it is a good idea to check what the market thinks about
the selling price of similar businesses.
The market approach offers the view of business value that is both easy to grasp
and straightforward to apply. The idea is to compare your business to similar
businesses that have actually sold. If the comparison is relevant, you can gain
valuable insights about the kind of price your business would fetch in the
marketplace. You can use the market-based business valuation methods to get a
quick sanity check pricing estimate or as a compelling market evidence of the likely
business selling price.
Pricing multiples for business selling price estimation
All business valuation methods under the market approach fall within one or more
of the following categories:

Empirical, using comparative business sale data.

Empirical, which rely upon guideline public company data.

Heuristic, which use expert opinions of professional practitioners.
Value measures and pricing multiples
Each of these business valuation methods uses a number of so-called value
measures which relate the business selling price estimate to some value of
business financial performance. Generally, these value measures are ratios, known
as pricing multiples, of the estimated selling price to a known financial performance
characteristic. The typical ones are:

Selling price divided by the business revenue.

Selling price divided by some measure of business earnings.

Selling price divided by the business book value.
For example, to estimate the business selling price you can take the business
revenue and multiply it by the selling price to business revenue pricing multiple.
One way to arrive at an estimate of the business selling price is to use a single
pricing multiple value, such as the average or the median. Another way is to
calculate a pricing range by using a pair of values, for example the minimum and
the maximum. The likely selling price will fall somewhere in between.
Market business valuation methods – pros and cons
A key difference between the various market-based business valuation methods is
how these pricing multiples are determined. Each method has a number of pros
and cons.
Comparative private company sale data method
Under this business valuation method, you gather data on sales of private
companies that closely resemble the business being valued.
Pros:

Comparison data includes sales of small businesses that are quite similar to
the small business being valued.

Availability of good sources of private business sales data.
Cons:

Insufficient market evidence in some industries.

Requires careful data selection, analysis and consistent data reporting
standards.
Public guideline company method
In this method, you review the data involving sales of ownership interest in publicly
traded companies that resemble the small business being valued.
Pros:

Plenty of transaction data available from the public capital markets.

Business sale data reporting is generally consistent and reliable.

Business financial reporting data are readily available.
Cons:

Comparison to small businesses may not be relevant.

Data generally involves sales of non-controlling business ownership interest,
not the entire company.

Data requires adjustment for lack of marketability of private company
ownership interest.
Heuristic pricing rules method
In this method, you use business pricing formulas that are developed based on the
expert opinion of professionals involved in business sales. The best known
professional group that does this is the business intermediaries that broker
business sale transactions in specific industries. Their knowledge of the market
place and direct exposure to transactions puts these experts in an excellent position
to estimate the likely business selling price.
Pros:

Pricing multiples based on the expert opinion of active market participants,
from the trenches.

Pricing formulas are often relied upon both by practitioners and their client
business owners and buyers when pricing a deal.
Cons:

Pricing multiples may not be backed by rigorous statistical data analysis.

Non-brokered business sale transaction data may not be included.
Business selling price estimates – which one is best?
Given these choices of market-based business valuation methods, what is the “best
practice” approach you can use? Since all methods have their strengths and
weaknesses, it seems that a combination of empirical and heuristic approaches may
be your best choice. Here is one suggestion:

Gather and study the relevant business sale data.

Select the appropriate business pricing multiples.

Use the pricing multiples to calculate the business selling price estimate.

Check this estimate against the heuristic expert pricing rules.

If the two estimates agree, you have the increased confidence in your
business pricing estimate.

If the estimates are wide apart, review your empirical data selection and
pricing multiples.

Assign a weight to each pricing estimate to calculate an average business
value.