The Three Primary Methods of Valuing a Business

Introduction

When planning for the ultimate transition of your business, obtaining a business valuation is usually one of the first important steps to take because regardless of what your time horizon is to exit (whether that be six months or six years), you have to know where you are right now on your exit planning journey. The valuation of a business requires one to look at a business in multiple ways because one of the key principles of valuation is the concept of substitution. That is, prospective investors are always considering competing investments, so if an owner prices their company unrealistically when trying to sell it, interested parties will most likely look to more appropriately priced companies as an alternative, rather than overpay simply because one owner overvalues their business.

In this article, we will discuss the three primary methods of valuing a company and expand on which ones are more commonly used in an exit planning context. Each of the methods has their own strengths and drawbacks, and we also must consider that the purpose of the valuation will play a large role in how we tackle a valuation assignment.

Asset Approach

The asset approach values a company based on the fair market value of the tangible assets backing the operating business, often referred to as the adjusted book value. This approach usually assumes the business has no intangible value, but rather its value is derived from an assemblage of assets that produces an operating company. Because we are performing this valuation for exit planning purposes, we assume the business is a going concern, thus the assets are appraised individually using a value-for-exchange rather than employing a liquidation approach.

For exit planning purposes, the asset approach is often not the preferred approach, since when an owner plans and exit, there is an assumption of transferability and a transferable business will most often transfer based on a value derived from one of the other two methods. However, the asset approach can play an important role in a number of ways even if our primary approach is using another method. For example, the asset approach can provide us with an idea of the tangible asset backing of the business. From this, the fair market value conclusion can be compared the tangible asset backing to assess the estimated goodwill. This is useful for asset intensive companies in that we can assess the reasonability of goodwill compared to the cash flows generated by the business from which a payback can be earned.

Income Approach

The income approach values a business based on its normalized cash flows. That is, the cash flows have been adjusted to reflect market values in owner and family compensation, occupancy costs, and removed the impact of non-recurring revenues and expenses. The income approach can employ either a single period model (often called the capitalization of cash flow method) or a multi-period model (the discounted cash flow method). In an ideal world, we would always value a business using a discounted cash flow analysis, but unfortunately, forecasting future cash flows is difficult and an unreliable forecast is unlikely to provide is with the best estimate of value for a business. Thus, in practice, it is not unusual, especially for companies under $10 million in revenues, to be valued using a single period model. The single period model comes with its own challenges in that the single period being valued needs to be an accurate reflection of future cash flows and not simply what has happened in the past. The value of a business from an income approach is derived by either applying either a capitalization rate or a discount rate to the forecasted cash flows. While capitalization and discount rates are beyond the scope of this article, they essentially represent the risk associated with achieving the forecasted cash flows.

The income approach is ideally most applicable to companies with the following characteristics:

  • Low asset intensity;
  • Predictable cash flows (or cash flows that can be reliably modelled);
  • A unique business; and/or
  • Operates in an industry with minimal market information.

Market Approach

The market approach values a business in one of two ways:

  1. Through examining market transactions of reasonably comparable companies to assess a range of multiples that can be applied to our subject company; or
  2. Examining guideline public companies that are comparable from which we can derive a range of multiples that can be applied to our subject company.

I am usually dealing with either main street (<$ 5 million in revenue) or Lower Middle Market businesses ($5 million to $20 million) in revenue, so it is rare that public companies are comparable to the subject company. Thus, the primary application of the Market Approach for middle market businesses will be what is often called the Guideline Transaction Approach (or sometimes referred to as the M&A Approach). One of the key advantages of the market approach is that we can use real world data, rather than relying more on valuation theory. However, the databases are sometimes limited in what data is available, thus limiting our ability to make comparability assessments. Also, for unique businesses, true comparable transactions may be difficult if not impossible to find. However, for many business at the Lower Middle Market and Main Street levels, some form of comparable data is likely available and should be used in any analysis.

From an exit planning perspective, the market approach is highly useful if good data is present since it will give us and the business owners a good idea of what the range of multiples is for a given industry. The range of multiples is important from an exit planning perspective because we want to be able to assess not only what the best-in-class multiples are, but also multiples for companies at the lower end of the range (representing companies good enough to transfer but not best-in-class). In an exit planning exercise, we cannot assume the subject company is transferable, so the valuation needs to be supplemented by a deep dive analysis into the value drivers of the business to assess how the subject company stacks up against industry peers. From this, an assessment can first be made on what the likelihood of transferability is, and secondly, what range of multiple the company might achieve if placed on the market based on our work.

Putting It All Together

Valuing a business is much like a court trial where evidence is presented from both perspectives and either a jury or the judge has to determine how much weight is going to be placed on evidence found to come to a conclusion. While we normally select a primary method for valuing a business, the other methods may also provide us with evidence that we can use to support our conclusions and thus will likely carry some degree of weight. When it comes to exit planning, it’s important to understand both the strengths and weaknesses of an organization then create an action plan to improve the value of the business. The owner of a business is not handcuffed by a valuation but rather the value of a business is fluid over time and can be improved through applying a strategic and incremental plan over a specified time frame that addresses the key value drivers of the business. That is the heart of value acceleration and it will help you as a business owner increase your transferability, the cash flows your business generates, and the multiple you will receive for those cash flows.

Key Takeaways

  • A transferable business is most likely going to be valued using either the income approach or market approach but the asset approach may serve as a good sanity test.
  • The primary methodology used to value a business for exit planning purposes will depend on the nature of the business being sold. The market approach is preferable but may not always be possible.
  • Given enough time, there is always room to improve both the operating performance of your business and its valuation, which is why starting the value acceleration process today is a critical first step.

 

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