There seems to be a lot of confusion among my clients about business valuation. They think that it is based on the potential market in their industry or some “blue sky” number that they can’t quite quantify. There are generally only three approaches used in business valuation: the asset-based approach, the market approach, and the income approach. Now, I’ve given away the punch line of which I think is best with the title of this article; but humor me as I describe all three options.
The asset based approach basically just looks at the value of the assets on your balance sheet. Simple, huh? It assumes that your business’s value is equal to the sum of its assets or net asset value. This approach can work for asset based businesses but really misses the mark with service businesses with little to no assets on the books. And it misses a company’s intangible assets like its reputation, strong client list, etc.
The market approach looks at comparable sales of similar businesses. This real estate approach requires that you find “comps” to your business that sold recently. Easier said than done with privately held businesses. And just because another ABC business sold for $XX down the road doesn’t mean that your business is worth the same amount. They may have superior (or worse) processes,
products, reputation, etc.
Finally, there is the income approach. This approach looks at the cash flows of the business, projects them into the future with a discount, and adds in the assets too. IRS Revenue Ruling 59-60 says that earnings are preeminent for the valuation of privately held businesses. The premise behind this method is that a company should not have a price higher than the amount of cash it will generate in the future. Also, the time value of money is factored in, ie., $100 today is worth more than $100 in ten years or
even one year.
Where people seem to get mixed up is the discount rate, so let’s talk about that. The discount rate is essentially a measure of how risky an investment in this particular company would be, or what the required return would be for investing. It’s composed of two parts, the risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, and a risk-free rate that compensates an investor for the relative level of risk associated with a particular investment. A typical investment will carry a discount rate somewhere between 9% and 17%.
The benefit of this approach is that a business’s client base, superior processes/products, good reputation, etc. is typically reflected in strong revenues and healthy cash flows. And healthy cash flows is what grows (and sells) a business. Cash (flow), as they say, is king.
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