Whether you're looking into buying a business, considering selling your business, or looking to describe the value of your business to venture capitalists, knowing how to accurate value your business is a crucial piece of running the company.
But untangling the various tangible and intangible pieces of your business and knowing how to accurate compute their value is complicated.
How should you find an accurate value for your business?
As SCORE (the Service Corps of Retired Executives) points out, there are many different ways to value a business.
Different businesses may take different approaches, and the best valuations use more than one method.
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The Income Approach
This approach is fairly straightforward; the business is valued based on its ability to generate income for the owners. This is also referred to as the business's "economic benefit." There are three different ways that are common for businesses to be valued based on their income.
- Discounted cash flow: This method considers several factors such as net cash flows, required investments to maintain those cash flowed, and the long-term potential sale price of the business are all examined. Essentially, the business is valued based on the amount of income it can generate over a set period of time.
- Capitalization of earnings: For this method, a business's expected earnings are divided by the capitalization rate, which represents the risk that the business owner is taking on by investing in the business. This values the business by considering how likely it is that the business will generate returns over time.
- Multiple of discretionary earnings: this computes the value of the business by considering the discretionary income stream and multiplying it by a variety of factors that represent the owner, business, and industry factors.
The Asset Approach
While the income approaches look to value a business's potential for earnings, the asset approaches place a fair market value on what a business actually owns. This could be equipment, real estate, patents, or digital accounts such as particular URLs. Anything a company could turn around and sell as-is can generally be considered an asset.
There are two common methods of valuing a business by its assets.
- Asset accumulation method: For this method, a business compiles a basic spreadsheet and compares of all its assets, both tangible and intangible, to all of its liabilities. The difference is considered the value of the company's assets. Think of this as what money would be left over if a business sold off all of its equipment, intellectual property, and physical location.
- Capitalized excess earnings method: This adds together the value of the tangible business assets with the "excess" earnings. The excess earnings are considered the business earnings that do not come from tangible assets.
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The Market-Based Business Approach
While both the income and the asset valuation approach consider what a business is worth by determining its actual earnings, the market-based business approach considers how much the market is likely to pay for a business. There are two main methods of computing this.
- Comparative market transaction method
- Guideline publicly traded company method
In both of these valuations, companies look at other businesses that are similar to their own business and see how much other businesses have sold for. This might be particularly useful for a business that expects to trade on its brand, or which is considered to have more potential than its balance sheets are likely to show.
Why Use All Three?
Most businesses use a comprehensive approach to valuation which draws from each of these areas. The reason for considering valuation is that every business has different a business model. A physical business built around customers coming to a brick-and-mortar store is going to have a very different valuation process from a business that mostly operates online and has more intangible assets than tangible ones.
CEOs and business owners who can comfortably and easily discuss the difference between their income streams, their asset valuations, and the comparative sale prices of other companies on the market will have the best chance of receiving a fair price for their business. Investors will understand that the business owner has a detailed comprehension of the daily operating process of their business, which will give them more trust in the valuation overall.
Even if you're not planning on selling your business any time soon, having a comprehensive valuation of your business is a good idea. When you go to raise capital, whether that be through investors or small business loans, showing that you have a thorough understanding of the economics of your business will only benefit you.