What are the Different Business Valuation Methods?
If you’re like most business owners, your business is your “baby.” You have raised it from concept to viable company, weathering the inevitable growing pains. It is difficult to view the business from an objective point of view – and this is exactly what is necessary when it comes to determining the value of the organization. A business valuation is about answering the question, “How much is this company worth? Not “How much do I think it’s worth?” The information gleaned through this process is critical for a number of reasons; from preparing for a sale or succession to securing financing. What are the different business valuation methods, and which is the most accurate?
When to ask What Are the Different Business Valuation Methods?
As mentioned, a valuation gives owners, partners, investors, and other key stakeholders an objective determination of the business’s worth on the market. That said, however, a company can have different values at the same time. It is determined by the price a buyer would be willing to pay. Different types of buyers, different prices. So yes, there can be various value determinations, depending on what method is used (and why).
Now, what are the different business valuation methods? Generally, we see three that professionals utilize most frequently:
This is a relatively simple approach that looks at the value of a business in terms of the fair market value of its net assets. This is particularly well-suited to businesses that are asset-intensive. For example, real estate companies may hold a lot of properties, which make up the bulk of their value. In this case, it makes sense that the valuation reflects this. Other cases in which the cost approach is suitable:
- For small businesses that do not have a lot of name recognition
- For investment, holding, and other businesses with significant underlying assets
- For situations in which valuation is necessary for financial or tax purposes and when there has been minimal progress on the business plan
In these situations, the cost approach is simple enough to execute, and it does not muddy the waters, so to speak, with forecasts of future cash flows. However, with businesses that hold intangible assets or that are operating companies, it is not thorough or nuanced enough to capture a real sense of the value.
With this valuation approach, worth is determined by comparing a business with similar companies with known valuations. For example, one might look at “comparables” that have sold recently. These figures can be accessed through sales transactions, similar publicly-traded companies, or shares in the company itself.
This does not provide a true “apples to apples” comparison – after all, companies have unique qualities (e.g. company culture, goodwill, marketing strategies, etc.) that are not replicated in comparables. At the same time, though, it can give a baseline value: that is, it works on the theory that buyers will only pay the market rate, which is based on transactions of similar entities.
Like the cost approach, the market approach is relatively straightforward. Unlike the former, though, it integrates both tangible and intangible assets. Low-quality or lack of sufficient data can affect the accuracy of the results.
The income approach is the most complex of these three valuation methods. It looks at the level, timing, and risk of cash flows. Unlike the cost and market approaches, this is forward-looking and weighs aspects like risk and opportunity costs. It is used in situations where businesses have positive future cash flows, relatively stable future cash flows, and/or future cash flows that can be forecast for several years ahead.
While it does factor in both tangible and intangible assets, as well as the unique characteristics of the company that may add to the value. On the downside, though, the income approach can become very complicated, and many underlying assumptions are required to arrive at a value. The expertise of the company performing the valuation is key.
Which Business Valuation Method Is the Most Accurate?
The income approach, while complex, is generally regarded as the most accurate of these valuation methods as it looks at more in-depth factors that influence value. But again, a business may have multiple values at the same time, depending on the purpose of the valuation.
Your company’s specific situation in terms of aspects like cash flow, progress towards the business plan, goodwill, assets, unique characteristics, etc., will influence which valuation method is best for you. Also at play is the industry and sector in which you are positioned, as well as the overall market.
The best way to arrive at an accurate valuation that will help you plan for the future and make solid, informed decisions is to consult with the experts. Contact AMB Performance Group to learn how your process will work.