Business valuation methods are analytical procedures or techniques used to determine the business value.
What It Means
Each of the three approaches to business valuation features a number of business valuation methods:
The methods provide specific mathematical procedures used to calculate business value.
From the standpoint of valuation methodology, the methods under each approach rely on the same economic principles. However, the procedural and mathematical details of each business valuation method may differ considerably.
Asset-based business valuation methods
Also known as the cost-based methods, these business valuation methods estimate the value of a business based on its assets and liabilities.
Business valuation experts often resort to asset-based methods for accurate business purchase price allocation, an important element of structuring a business acquisition.
The typical methods under the asset approach include:
- Asset accumulation
- Capitalized excess earnings
The asset accumulation method uses a procedure for estimating the values of individual business assets and liabilities. The difference between the combined values of all assets and liabilities represents the business value. However, the method goes beyond the typical cost basis accounting balance sheet.
To clarify, this method lets you consider important off balance sheet assets such as internally developed intellectual property, customer lists, and valuable business agreements. On the liability side, the method accounts for contingent liabilities such as pending legal action judgments and costs associated with regulatory compliance.
A classical asset-based valuation method is Capitalized Excess Earnings, also known as the Treasury Method. In addition to business value calculation this method helps you determine the value of business goodwill.
The income methods, as the name implies, determine the value based on the company's income producing capacity and risk. All such methods calculate the present value of the company based on a forecast of earnings which can be a single number or a stream of expected income.
The main mathematical procedures used by these methods are capitalization and discounting. The discount and capitalization rates represent business risk.
Income business valuation methods most commonly used in business appraisals are:
- Capitalized earnings
- Multiple of discretionary earnings
- Discounted cash flow
The typical capitalization methods that use a single earnings number as input are Multiple of Discretionary Earnings and Capitalized Earnings. On the other hand, the Discounted Cash Flow business valuation method is the best known way of determining business value by discounting a stream of future income.
Market-based valuation methods
These methods help you estimate the subject business value in comparison to the recent sales of similar companies.
Professional business appraisals often include these market valuation methods:
- Guideline publicly traded companies
- Comparative transactions
Market methods let you figure out your business value by comparing your company to similar businesses that sold recently. For private companies, the sales of similar privately-owned businesses can offer a compelling source of market comparables. However, the quality of such data tends to be less reliable than transaction data filed by public companies. As a result, transactions involving small capitalization public companies may provide more reliable evidence of business value for privately owned firms. However, you would need to make an adjustment to such value estimates for the relative lack of marketability of private companies.
Valuation Multiples derived from comparable business sales are the typical tools you can use to estimate business value.
Use of multiple methods in professional business appraisals
Depending on your analysis, the results you get from different methods may disagree. Therefore, all professional appraisal standards require that you use a number of valuation methods from each approach.
To put together a well-rounded picture of business value, you can combine the results of several business valuation methods by averaging the numbers or indicating the range of values, from low to high. This process is often referred to as business value synthesis.