Accurately determining the value of a business is an important part of the business buying process. Explore the three primary ways that Certified Valuation Analysts use to assess the value of a particular business. Whether you are buying a business or selling a business, an accurate valuation takes all three of these methodologies into account, then uses the one most appropriate for your situation Discover how these different approaches can affect the value and subsequently impact the business buying process.
I’m a Certified Valuation Analyst, among other things, which means I’m qualified to value businesses. Why would we want to value a business? It might be because we are looking into buying a business, and we want to make sure that we don’t pay too much for it. It could be that we are selling a business, and we’re looking at making sure that we get all that we can out of it. It could in an estate situation where you die and you need to report the value of the business. It could be in a gifting transaction or one of many different reasons.
When you are looking at valuing a business, I wanted to talk a little bit about the methodology that we use, so that you can understand that better when you’re trying to determine value or assessing value on something that you are buying. When we value a business, there are really three approaches to valuation, and all three approaches need to be considered. We know that business brokers use rules of thumb, and there’s often rules of thumb in an industry that give you an idea as to what something is worth, but when we do a valuation, as a Certified Valuation Analyst, we do have to take everything into account. The three methodologies are the Asset Approach, the Market Approach, and the Income Approach. And this is true if you’re having a real estate appraiser appraise your house, they take all of those into account. We, too, take all of them into account when valuing a business.
Let me briefly describe each. The first is the Asset Approach. The Asset Approach simply takes a look at what the fair market value is of each underlying asset. It looks at the vehicles and equipment. Certainly, the cash in your checking account is worth whatever the cash is. About your accounts receivable, are they worth what people owe you, or is it likely that you’re not going to collect on some of them, and it needs to be discounted? In any case, the Asset Approach says we’re going to look at it like we’re taking each of these assets and selling them individually off. What would I get for them? We total that up, and that is one measure of value in a business. The problem with using that method, though, is that it doesn’t take into account something that we call good will or blue sky. What sort of reputation has the business built? What sorts of customer base and customer lists are there inherent in the business? All of those things, often, add value, and you should get something more than just the value of each underlying asset. You should get something for that blue sky or good will. So, what I find is that when we use the Asset Approach, it sets the base, the minimum that you ought to be able to sell the business for. Then we go onto the next one.
You can see that the next one is the Market Approach. The market approach is what they use most often when valuing homes and real estate. Real estate appraisers will take and compare your house or your real estate to other properties that have sold within a particular period of time, make some adjustments, and have a pretty good idea as to what your house will sell for. Well, we can do that in business too, because there are databases published of businesses that have sold, throughout the country, over the last number of years. The difficulty with it, of course, is trying to find a business just exactly like yours or the one that you want to buy. So, even though these are significant databases of information, typically, it’s really hard to find enough market data to make an actual comparison. So then we move to the third item which is the Income Approach.
Although we call it the Income Approach, I’ll use a different example for you. I like to use cash flow, as many valuation analysts do. You can’t spend income, but you can spend cash. So, we take a look at what sort of cash that the business is generating, what its extra cash flow is, if you will. What money can be taken out of it, each year, by the owner? And whatever that cash flow that can come out to you is, it has a value and we capitalize that value. A simple way to do that is, if we wanted a 25% return on our money, and a business was generating $100,000 a year in cash flow, well then, you’d be willing to pay or sell for $400,000, because $400,000 times 25% is $100,000 a year. So it’s a simple process of finding out what the cash flow is, and then assigning a risk value. The difficulty for someone who doesn’t work as a valuation professional is that you’re not really sure what that risk factor should be or what that capitalization rate should be. So, one of the things that valuation analysts do for you is that they determine what that multiple might be.
In another video that I have on valuing a business, I’ll walk you through, just kind of a quick, dirty, and simple way, how to do this income method to value the business. It tends to be the most often used methodology because it takes into account, not only the assets, but also, that good will or blue sky, and gives you a truer measure, in most cases, of what the value of that business is. It’s good to understand these three methods, and a good valuation person will consider all three, and then choose the one that is most appropriate in valuing your business.