What Valuation Approach Should You Use?
Before you decide to sell your business, you need to calculate an accurate purchase price for it. Business valuation refers to the general process of determining the economic value of a company in whole or in part.
When you sell your company, you must first differentiate between its value and price. Price refers to the monetary amount paid for the company at the time of its sale. It depends on the supply and demand factors of the market at the time of the sale. A company’s value is what the prospective buyer is willing to pay to own the business and is determined by how useful the company will be for the new owner.
What Is Valuation and Why Is It Important?
In negotiations between prospective buyers and sellers of companies, determining company value plays a central role. Company value is usually subjective, not an objective number.
Many business owners either underestimate the process of business valuation or are ignorant of the entire process and what it entails. This is understandable, as business valuation is a complex process with several approaches. Irrespective of the method you choose, business valuation entails measuring all current value-creating assets and elements of the company, analyzing its position in its industry, and managing future financial expectations.
What gets measured and how determines the choice of valuation approach where all factors like industry sector, company size, expected cash flow, type of product or service, etc., are considered. The nature of your business and its requirements determine the choice of valuation approach.
One must also note that each valuation approach differs significantly from others, and each method caters to a distinct set of conditions. Consequently, it is necessary to fully understand your current situation and business requirements before choosing the valuation approach.
Business Valuation Approaches
There are three main approaches to business valuation: income, asset, and market.
The income approach uses the economic principle of expectation and looks at the business from how much money the business is expected to make in the future.
Buyers will look at your business and consider what economic benefits they will get if they invest in it. Considering future expectations means the money is not yet in the bank, so there is a risk associated with the business. All elements that could affect future income are considered while calculating the value of the business using this approach.
The income approach is also known as the income capitalization approach; the capitalization rate of the business is divided by the net operating income.
- This approach is most commonly used for real estate, hotels, and buildings that generate income. While it considers the rent (if applicable), it may not consider other factors such as the building’s condition, neighborhood, location, and other financing exceptions.
- Additional maintenance costs, repairs, and how efficiently the property is used are a few essential factors to consider, as excessive repairs and maintenance costs impact the property’s future income. Moreover, a well-run property also affects the net operating income of the business as a whole.
In the asset approach, the business is evaluated from the standpoint of its assets and its liabilities. Since all operating companies have assets and liabilities, valuing them is necessary. Both the assets and liabilities are evaluated, and the difference between the two values sets the value of the business. While it may sound simple, deciding which business assets and liabilities should be included in the valuation and determining their worth is a daunting task.
For example, a landlord may use external appraisers to evaluate the worth of his property. Since property value increases over time, he would know that his property is worth more than it was five years ago. Therefore, the property’s new, higher value will be fixed and used in an asset-based approach. On the other hand, liabilities usually have an accurate market value.
This valuation approach is flexible in terms of the interpretation of assets and liabilities under consideration for valuation. It enables a buyer to determine how much it would cost to recreate a business (similar to the one on the market) that will yield the same commercial returns to the owner?
- The asset approach is practical for valuing securities of companies engaged in selling and developing the real estate, investment holdings, petroleum, and other natural resources business organizations. Financial and real estate investors also use this valuation approach.
- This approach yields the lowest valuation but provides the most appropriate value in certain situations. For example, an airline losing money has fewer flying sectors and routes, but higher operational and labor costs will lower valuation. However, a competitor will view the same assets (flying routes and sectors, equipment, landing rights and approvals, fleet of aircraft) with significant value. So here, the assets will be valued separately and be set aside from other money-losing aspects.
- Unlike other methods, the asset-based valuation approach disregards the business’ anticipated earning potential, so a business’ value could be much higher when compared to the value of its existing assets. Moreover, evaluating intangible business assets is complicated, as balance sheets do not accurately reflect their value.
The market approach is used to appraise the value of a business by comparisons to similar businesses that have been recently sold or are available for sale.
The market approach reviews comparable asset prices to adjust for different quantities or qualities. For example, suppose you want to acquire the ownership shares of a business. In that case, the recent selling price of shares of an identical company is a good point of reference to estimate their fair value.
There are two primary valuation methods under this approach:
- Public company is comparable. The valuation metrics of publicly traded companies similar to the target company are used for comparison. However, it is challenging to attain direct comparability since the company size and industry of operation may be dissimilar to the subject company.
- Precedent transactions. The value is derived using pricing multiples based on transactions of companies in the same industry as the subject company.
- This approach is preferred by publicly traded companies and residential real estate companies as there is ample data to make the comparisons.
- The calculation is straightforward.
- The data used is publicly available and accurate and is not dependent on subjective forecasts.
Which Approach Is Suitable for Your Business?
The key objective of business valuation is to identify all value-generating aspects of the business. So, it is essential to understand that your choice of valuation method should suit the nature of your business and should fulfill legal requirements.
Different types of businesses will be valued differently based on what the company has because there is no universal business valuation formula suiting all businesses. Don’t overlook the fact that the valuation process of small businesses differs from that of large companies. Small companies face complicating factors such as lack of credible records and questions about the transferrable value of the business due to over-reliance on sole proprietorship. Lack of clarity of asset ownership also plays a significant role.
Business valuation is technical, so the advisor must have adequate financial knowledge and expertise. In addition, the evaluator should be well-versed in the company’s business model and operational strategy and have an in-depth understanding of the market.
Make the Right Choice
Choosing a valuation method for a specific company needs careful thought about what the business has and how it will best fit into the approaches. Moreover, business valuation is not only required for exit planning; it has other wide-ranging uses. For example, business valuation is also required for acquiring business loans and planning business expansion. Understanding this is imperative, as the wrong choice of valuation approach may lead to significant financial losses for your business.
Our team of experts at Quantive can assist you every step of the way, from business valuation to deal closure. Get in touch today.