Understanding Business Valuation Methodology
Business Valuation Methods Every Stakeholder Should Know
When it comes to business valuation, the methodology used to reach a valuation matters significantly. The value of a tire manufacturer that has been in business for 70 years, with national distribution and a stable customer base, should not be determined by the same method used with a cloud-based ride-sharing business that is less than 10 years old.
The appropriate method – or a combination of methods – for a business valuation is determined based on the specific facts and circumstances of the business being valued and the purpose of the valuation.
It’s important to remember there are several stakeholders in any business valuation, regardless of the reasons the valuation is being performed. For instance, there is the business owner or multiple business owners, the potential buyer if the business is being sold, and potential heirs if the business is part of an estate. Beyond these stakeholders, there are bankers, lawyers and other professionals who must be satisfied that a business is appropriately valued. In the case of an Employee Stock Ownership Plan (ESOP), there may be an employee group that also has an interest in the valuation.
All stakeholders will want to ensure that the appropriate methods have been used to determine the value of a company. The most commonly accepted business valuation methods and their advantages include:
With the income approach, the focus is on income statements, net income and cash. The valuation professional performs an analysis of potential economic benefits of the business and the risks associated with it, based on income. The income approach can be used to determine majority or minority interest position, as well. Returns that are available to both equity holders and debt holders are included in the analysis.
The earnings approach encompasses two different methods:
- The capitalized earnings method is appropriate when current level of operations and profit is representative of how the business will be going forward. In other words, the business is stable from the standpoint of operations, revenue, earnings, and customer base. This method looks at a single period estimate of benefit as being representative of the company’s future potential.
- The discounted earnings method is appropriate when a business is going to see some volatility in the immediate future – perhaps over the next two to five years – but is expected to stabilize. This could apply to many rapidly growing businesses in emerging industries. Realistic management projections are a key factor in this methodology.
This is a straightforward approach that involves determining the value of a company based on the selling price of similar companies. While it can be tricky to find true comps in the marketplace, this method is appropriate for holding companies, capital asset-heavy businesses, or businesses that are performing poorly where the assets may be worth more than the operating company itself.
The asset approach is most appropriate when valuing a holding company or capital asset intensive company, or when valuing a controlling interest. Asset methodologies are balance sheet driven and involve adjusting individual assets and liabilities on the subject company’s current balance sheet items to defined values. The weaknesses of the asset approach are that it may not value the intangible assets of a company, such as goodwill, or focus on income generated by a company’s assets as a whole.
The cost or asset approach is applied in the valuation of a broad range of different assets. The valuation of tangible assets considers that certain assets have a fair market value that differs from their book value on the balance sheet. This approach presents the value of all the tangible and intangible assets and liabilities of the company at their fair market value.
Adjusted Net Asset Value Approach
The adjusted net asset value (“ANAV”) method is the amount for which a controlling ownership interest could liquidate the underlying assets and liabilities (without consideration for any transaction or selling costs). The ANAV is the sum of the total market value of a company’s assets minus its liabilities. This approach is sometimes used in the valuation of operating companies where the value of the underlying assets is greater than the value of the business as reflected by the earnings or cash flows being generated from such assets.
If you would like to discuss a business valuation for your company, please contact an Adams Brown advisor.