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What is a Business Valuation?

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What is a business valuation? It sounds like a straight-forward question, right? But underneath the surface of a not so clever name, a business valuation is made up of several different – and critical – pieces that come together to determine an assessment of the total value of a business. Business valuations are crucial when planning to sell a business.

A proper business valuation is made up of three different possible calculations, known as approaches. These three different approaches, and the results of each, are analyzed independently and constructively when determining a final value for a business. Let’s discuss each of these approaches, what they mean and how they impact a valuation.

  1. Asset-based approach: The asset-based approach, sometimes referred to as the cost approach, focuses on assets rather than income or market values. During this calculation, each component of a business is valued separately and summed up to derive the total value of the enterprise. The appraiser estimates value by estimating the cost of duplicating or replacing the individual elements of the business property being appraised, item by item, asset by asset. Only the tangible assets of the business are valued in this calculation. Intangible value – which many businesses have – is not accounted for during this analysis, which is one critical reason it cannot be used alone to provide an accurate and holistic picture of a business’ value.
  2. Income approach: The income approach, sometimes referred to as the investment value approach, focuses on income instead of market value or business assets. This approach assumes an investor could invest in a property with similar investment characteristics, although not necessarily the same business. The computations generally determine the value of the business is equal to the present value of the future benefit stream to the owners. This is accomplished by either capitalizing a single period income stream or by discounting a series of income streams based on a multi-period forecast. Since estimating the future income of a business can be speculative, historical data is generally used as a starting point for reference under the premise history will likely repeat itself. The future cannot be ignored, however, since valuation is a prophecy of the future.
  3. Market approach: The market approach is fundamental to business valuations as fair market value is determined by the market. Under this approach, the appraiser attempts to find guideline companies traded on a public stock exchange, in the same or a similar industry as the appraisal subject, that allows a comparison to be made between the pricing multiples the public company trades at and the multiple deemed appropriate for the appraisal subject. Another common variation of this approach is to locate entire companies that have been bought and sold in the marketplace, publicly traded or closely-held, that allow the appraiser to determine the multiples that resulted from the transactions. These multiples can then be applied, with or without adjustment to the appraisal subject.

Residing within each approach lies a tremendous amount of research. Separate asset and real estate appraisals, SEC filing reviews, private sale database cleansing, normalization adjustments, discount rate build-ups and control/marketability premiums and/or discounts are all considered. While several companies continue to roll out online business valuation calculators, it is important to realize the limitations of a strict input-output calculation. A lack of discernment of the qualitative details noted above, in addition to those that are strictly quantitative can provide an incomplete picture. Choosing an expert that understands each of the three approaches and the vital underlying work that permits for an accurate and defend able conclusion is critical.

Tim Bograkos

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