As a savvy business owner, you’re likely asking your trusted team of advisors to conduct annual business valuations. Even if you don’t think a sale of your business is on the horizon, regular valuations give you an inside look at where your company stands relative to similar businesses in the industry. These valuations serve as a measuring stick and can help you make strategic decisions.
In this guide, you’ll learn about the three primary business valuation methods used by advisors. Specifically, you’ll learn about the pros and cons of each and the situations when your advisor may choose to use a particular method. Ultimately, you should have a much better understanding of how your advisor will go about determining your business’s value.
Business Valuation — The Basics
A professional business valuation allows you, as the owner, to get a third-party estimate of how much your company is currently worth. Too often owners wait until they are ready to sell to have an outside valuation performed. This can lead to problems with the sale, primarily due to a phenomenon known as the valuation gap.
A valuation gap exists when an owner thinks their company is worth more than it actually is. For instance, let’s say you operate in the lower middle market (annual revenues between $5 million and $25 million). As you start looking to sell your business, you may very well think that you’re going to get $20 million from the sale. However, your advisors quickly discover that the most your company is likely to sell for is $15 million.
Do you keep working in hopes of increasing the value of the company? Or do you sell your business for less than you were hoping, which could impact your retirement and estate plans?
In this scenario, if you had conducted regular professional valuations, you would have had a much better idea of what your company was worth. This would have given you the opportunity to make strategic decisions along the way, allowing you to address pain points and help boost the company’s value.
It’s also worth mentioning that the sale of your business may not always happen as you anticipated. As Mercer Capital describes in their Business Transfer Matrix, “ownership transfers are either voluntary or involuntary because we do not always control the timing or circumstances of sale.”
During the professional valuation process, your trusted team of advisors will consider many factors to determine the value of your business. They will analyze your financial statements. They will make subjective interpretations, such as Adjusted Earnings Before Interest, Depreciation, and Amortization (EBITDA). They will also use multipliers to see how your business compares to others in your industry.
Not only is it important for you to understand the value of the business, but it’s also important that you understand how your team of advisors arrives at that conclusion. Advisors can use several different business valuation methods and knowing what those are allows you to prepare yourself for a sale, even if you don’t think that day is imminent.
Types of Business Valuation Methods
Advisors typically use at least one of three business valuation methods to help determine the value of a business:
- Asset Method
- Income Method
- Market Method
You may also hear these referred to as “approaches” instead of “methods.” The terms are often used interchangeably by business owners going through the sales process.
In addition, you might hear about the Cost Method. This term is often used as a synonym for the Asset Approach (or Method). However, this is a faulty application for businesses operating in the lower middle market. The Cost Method is a specific real estate term that does not apply to the context of preparing a lower middle market business for the merger and acquisition (M&A) process.
With those guidelines in place, below is a breakdown of the three primary types of business valuation methods.
1. Asset Method
The Asset Method (or Asset Approach) primarily uses a company’s assets to come up with a valuation. Specifically, it focuses on a company’s tangible net asset value, which is the value of your assets less your liabilities. This method also takes the book value of your assets and restates them to their market value, removing considerations like depreciation.
Pros of the Asset Method
The balance sheet rarely recognizes the current market value of tangible assets. The Asset Method allows you to determine the going rate for the assets you own. If your company has a lot of assets or you’re conducting an asset sale (in which everything you own is going to be sold individually), this business valuation method could offer a more accurate expectation of what you will earn. Be sure to factor in your taxes, as they will diminish your overall rate of return.
Cons of the Asset Method
If you have numerous intangible assets, such as intellectual property or significant and proprietary operating procedures, your advisor may need to use one of the other business valuation methods to capture the full picture. The asset method also ignores the value of cash flow from operations.
When Your Advisor Will Use the Asset Method
Your advisor will likely use the Asset Method if your company is a “going concern,” meaning that the business is expected to operate into the foreseeable future without fear of liquidation. Essentially, it means your company has a healthy balance sheet and can meet its financial obligations.
If your business is not considered a going concern, it’s still possible that your advisor would use the Asset Method. This could be the case if the value of your business is tied directly to the liquidation value of its tangible assets.
Lastly, if you are receiving a certified valuation, the Asset Method may be used in part to determine the Fair Market Value of your business. Fair Market Value is a specific term used by the Internal Revenue Service (IRS) for financial and tax-reporting purposes.
2. Income Method
The Income Method (or Income Approach) focuses on cash flow. More specifically, it focuses on how much cash your business has, when that cash comes in (or goes out), and the risk associated with the business’s cash flows.
The thought process behind the Income Method is that investors view the value of a company as an investment. As such, the Income Method measures the net present value (NPV) of future cash flows using the discounted cash flow method (DCF method). Your advisor will apply a discount rate to future cash flows to account for the risks associated with the asset or liability. Examples of such risks include inflation or changes to tax rates.
Pros of the Income Method
The Income Method stands out because it focuses on estimated future cash flows of the business. It does not rely on similar past transactions or comparable companies, which could put your company in a positive light. Additionally, it derives value from both tangible and intangible assets, which can further boost your company’s value.
Cons of the Income Method
If your company does not have positive net cash flow from operations, the DCF method will likely not be effective. The Income Method also requires a lot of assumptions to be made about your business. Experienced advisors are well-versed at figuring out how to make and interpret these assumptions, but it’s worth noting that the process can be a bit subjective.
When Your Advisor Will Use the Income Method
If your business is established and profitable, your advisor may use the Income Method during your valuation. It can also be useful for businesses that anticipate high growth rates over the next one to five years.
3. Market Method
The Market Method (or Market Approach) focuses on your business compared to similar companies in your industry, commonly referred to as “comps.” Your company, known as the subject company, is priced relative to these similar companies in your industry.
The theory behind the Market Method is that investors will only want to pay the current market rate for a company.
Pros of the Market Method
The Market Method is a bit less intensive than the Income Approach. The valuation considers both tangible and intangible assets. It also relies much more on quantitative data, since it relies heavily on comparisons to information from similar companies.
Cons of the Market Method
The biggest con of the Market Method is that it could be difficult to find a suitable comp for your company. There is no Multiple Listing Service (MLS), per se, for private businesses. Some advisors will try to compare your business to public companies, which could be challenging if you own a startup or a new small business, or rely on their own expertise and industry experience.
Additionally, the comparison can be a tough nut to crack because you likely don’t have a share price to give an indicator of how the market values your business relative to other publicly traded companies.
When Your Advisor Will Use the Market Method
If your business is in an industry with a lot of comparable data, your advisor may be more willing to use the Market Method. This approach would also be enticing if the Income Method is not feasible, perhaps because a pattern for your business’s future cash flows has yet to be established.
Conduct Your Business Valuation Today
Even if you’re not ready to sell, a professional business valuation can be a useful tool. A valuation allows you to see the true value of your company. As demonstrated by the three different business valuation methods, there are multiple ways for your advisor to determine what your company is worth.
Choosing a team of experienced advisors makes it more likely that you’ll receive an accurate valuation of your company. For that reason, you need to choose advisors you can trust, like the team at Allan Taylor & Co. With more than 15 years in the M&A industry, Allan Taylor & Co. can help at any stage of the business valuation process. Contact us today to learn more.