Taking a proactive approach to managing the value of your business is key to your long-term success. Whether you plan to sell your business before retiring or aim to pass it down to the next generation, understanding your business’s value – and the factors that drive it – is essential.
Business valuations are important in all kinds of scenarios: from estate planning to preparing to negotiate the sale of your business. Despite that, it’s a topic many business owners overlook. And while the value of your business isn’t a number you’ll track every month, it’s one that you should at least have a rudimentary understanding of.
Building that understanding means you need to have a basic knowledge of the key methods used to value a business. Once you understand how your business is valued, you’ll understand how you can grow that value over the short, medium, and long term.
In this overview, we’ll break down the three key business valuation approaches and their underlying methods, exploring the key characteristics, pros, and cons of each approach in simple, practical terms.
An Overview of Business Valuation Methods
When you engage a business valuation firm to determine the value of your business, it’s natural to be curious about the process used to determine your business’s worth. Many entrepreneurs dedicate their lives to building their business, and they may be relying on the sale of their business to fund their retirement.
Depending on the situation and the type of business valuation report you seek, business valuation analysts use a blend of several methods to arrive at a data-backed determination of the value of your business. Broadly, these methods are grouped into three approaches: asset-based, income-based, and market-based.
Under the asset-based approach, business valuation professionals scrutinize the value of your company’s assets as listed on your balance sheet. These assets are adjusted to fair market value. Your company’s liabilities are then subtracted from this number to compute the net asset value of your business.
This approach is frequently used for investment holding companies and is also widely used in gift and estate planning. This approach is well-suited for asset heavy companies with little-to-no goodwill.
Asset-based approaches to business valuation are useful in many instances but do not capture the goodwill associated with the business. For that, valuation analysts typically use income and market-based valuation techniques.
Income-based approaches to business valuation assess your company’s financial performance (both historical and forward-looking) to determine the value of your business. These methods rely on cash flow forecasts, with the value of your business based on the future expected cash flows.
There are two main methods used under the income-based approach: the Discounted Cash Flow (DCF) method and the Capitalization of Cash Flow Method.
The DCF method is based on the premise that a business is worth the present value of its projected future cash flows. To calculate this, business appraisers must determine three key figures:
The DCF method offers the most accuracy and flexibility, and therefore is favored by many business valuation analysts. It’s a good fit for companies going through a growth period, balancing the potential value of future cash flows with the appropriate level of risk.
The Capitalization of Cash Flow method (also referred to as the Capitalization of Benefits method) works in a similar way but is better suited to mature businesses with stable earnings. Because growth is assumed to be stable, this is a more straightforward calculation that, theoretically, arrives at a same or similar conclusion to the DCF method.
There are two primary methods to consider under the market-based approach: the guideline public company method and the guideline company transactions method. The goal of the two approaches is to identify potentially comparable companies that are publicly traded, or whole companies, either privately or publicly owned, that have been involved in mergers and acquisitions. It’s important to note that these methods require the analyst to be able to ensure that the public company data is sufficiently comparable and that there is sufficient data from the sale of similar businesses to support an analysis
Business appraisal professionals typically calculate a business’s market value by applying a multiple to a business’s cash flow, such as revenue or earnings before interest, taxes, depreciation, and amortization (EBITDA). These multiples are determined by analyzing the multiples achieved either by comparable publicly traded companies or private companies that have recently sold. Often, the valuation analyst will have to make several adjustments to the comparison companies’ financials and valuation metrics in order to adjust for differences with the subject company.
There are a wide variety of methods that can be used to value a business. Selecting the most appropriate is extremely important to arriving at an accurate conclusion. The business valuation firm that you engage can work with you to define your goals and deliver a report that provides you with the data you need to make informed decisions and meet your compliance needs.
Experienced valuation professionals apply their professional judgment to determine not only the most appropriate methods, but also how to weigh these methods in their final conclusion or opinion of value. Sometimes, circumstances mean that certain approaches should be disregarded and others elevated in importance.
At HoganTaylor, our business valuation professionals bring a bespoke approach to every engagement. Our team assesses your business as it stands and applies the most appropriate methods to arrive at a data-backed valuation. In many instances, our team works to help clients better understand how their actions can impact their business’s valuation, with the goal of helping to create long-term enterprise value. Our innovative processes allow us to assist our clients nationwide, without sacrificing quality.
To learn more about HoganTaylor’s business valuation services, talk to an expert today.
If you have any questions about this content, or if you would like more information about HoganTaylor’s Forensic, Valuation & Litigation Support practice, please contact Clay Glasgow, CPA, ABV, CFF, CFE , Advisory Partner.
INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.