Valuations for the Novice, Part II

In addition to Standard of Value and Premise of Value which we discussed last month, another important concept is the Valuation Approach.

Valuation Approaches

The valuation approach is the actual method of valuing the business. The most commonly used methods fall into one of three general categories. It should be noted that in valuation engagements, the valuator is expected to consider all three methods.The three approaches include:

Asset Approach: the value is based on the company’s balance sheet; it is the difference between the company’s assets and liabilities adjusted to their fair market value. Common adjustments include revising Accounts Receivables to account for likely bad debt, and adjusting Fixed Assets to their estimated market (not depreciated) value.

This approach does not consider goodwill and – for an operating company, it is generally the floor, below which the company’s value should not fall. It is critical to value a company using this approach as I have seen many cases in which this approach is the determinable value because there is little goodwill in the business.

Market Approach: the value is based on a multiple, which is applied to the company’s revenue or earnings. Several national databases exist which compile data from small, privately-held companies which have sold. The theory is that “like” companies should sell for the same or similar multiple.

The problem is that no two companies are really the same. And even if they were similar, there is no way to glean that information from the databases. For instance, do they serve similar markets? Is the depth and breadth of management the same? Is the quality of revenue the same? The list goes on.

While this approach is problematic, it still provides a data point which can be valuable in assessing the range of possible valuations.

Income Approach: the value is based on the earnings of the company adjusted to reflect management by a non-owner operator. Common adjustments include removing personal expenses which have been passed through the business and replacing owner’s compensation with a market salary, to name a few. Other adjustments, include removing non-operating and non-recurring revenue and expenses.

The adjusted earnings provides a picture of the anticipated economic benefit stream of the business which would be available to a financial buyer.

The income approach applies a discount rate and converts the future cash flows into a present value dollar amount. The discount rate is determined based on a number of variables, including the risk associated with the company in question.

The income approach is generally the most appropriate method to value operating companies which have goodwill.

The determination and use of these concepts have a significant impact on the value of a business. It is critical that they are chosen wisely based on your situation. 

We are certified business valuators. If you would like to see how these concepts might impact your business, please give us a call.