Valuation Methods – Three Main Approaches to Value a Business

Knowing the value of your business is critical to effective planning. There are three different methods to determine the value of a business:

Business Valuation

The Asset Approach

Going Concern Value Method – what are the assets worth in place with the business functioning, less the liabilities, so it’s equal to the net equity.

Liquidation Value Method – the net amount that would be realized if the business is terminated and the assets sold off.

The Market Approach

Market Value Method – this method analyzes completed transactions of comparable  companies and applies the multiples of EBITDA and revenue to the subject company to arrive at a value. Comparable companies must be in a similar industry, similar in size, and fairly recent to be relevant. Multiples based upon EBITDA are generally more relevant than multiples based upon revenue.

Public Comparable Method – this method computes the multiples of earnings and revenue for public companies in the same industry, then discounts for lack of marketability and lack of size.

The Income Approach

Excess Earnings Method – this method uses a capitalization of earnings, after adjusting for an economic return on invested assets. The capitalization rate selected to be used is critical to the value, and input from the market value method is relevant. The excess earnings method is generally close to the valuation of a business to a financial buyer.

Discounted Cash Flow (DCF) Method – this method values a business based upon the future projected cash flows discounted back to their present value. In the DCF method, the valuation professional must compute the “cost of capital” for the business, by determining the applicable interest rate on debt, rate of return on equity, and the mix of debt to equity. For instance, let’s assume the business is borrowing from a bank at a rate of 5%, investors require 25% return on equity, and the percentage of debt to equity is 50%. The cost of capital would be the net after tax cost of debt ( 35% tax rate) or 3.25% plus required return on equity of 25% in this example = 28.25%, divided by two ( 50/50 debt to equity) or $14.13%.

Each of these business valuation methods also relies upon several very important factors that impact valuation and must be considered:

Company – revenue and EBITDA performance, depth of management, recurring revenue stream.
Industry – competitive positioning, distribution of customers, industry trends, depth of acquirers.
Capital Markets – overall economic outlook, cost and availability of leverage, equity in the market.

Other factors include a) degree of dependency on owner, i.e. how many of the customers rely on the personal relationship of the owner, b) depth of the management team - how well does the company perform when the owner is away, c) does the company have a clearly defined plan for growth? This may include acquisition targets, new geographic markets or customer segments, with a clearly defined road map and plan to execute, and d) what percentage of the business is “recurring” revenue and what percentage is “project based” revenue. Multiples are much higher for recurring revenue-based businesses.

Remember that business valuation is not an exact science, and the method that works for your friend’s business might not work for yours. The size of your business, your growth rate, industry, stability, profitability all are important factors impacting valuation.  

The business owner will typically want to know that is the “goodwill” value of the business. The goodwill value represents the excess value of the business, over and above the value of the assets in place.

Goodwill Value Example

Our firm had a client several years back that had been in business almost 30 years. This client had consistently spent close to $100,000 per year on media advertising to build brand awareness. The brand is well recognized in Central Texas, primarily from radio advertising consistently purchased over many, many years. Our firm worked up a valuation analysis of the business from the historical financials, went over the various methods with the owner, and presented our opinion of value. The owner agreed with our analysis, but then asked:  Where is the value of all the advertising we have done over the past 30 years to build the brand in the marketplace reflected in the opinion of value?

While it was a very good question, the answer was that the revenue and EBITDA generated by this well-recognized brand was already reflected in the valuation, and therefore included in the “goodwill” value. Let’s remember that many companies have well-recognized brands, but the ultimate value of that brand is based upon profits.

At the end of the day, most companies will have goodwill value in excess of their asset value, and that goodwill value is derived from the ability of the company to generate consistent earnings.

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