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Business Valuations and Financing
All You Need to Know About Business Valuation Methods
Business valuation methods are used to determine the economic value of a business or the fair value of a business which includes: sale value, tax expenses (estate, buy sells, Esops, etc.), and legal expenses (bankruptcy, divorce, and shareholder disputes). If you are buying or selling a business, read below to understand how valuations can help in determining the value and worth of a business so you can buy or sell with confidence.
Top 3 business valuation methods:
When selling a business, the building blocks for calculating its value starts by understanding the different key approaches to each of the three main types of valuations. The asset, market, and income approach are the three most common business valuations, and understanding these will allow you to decide which one is right for the sale of your business. A Sunbelt Business Broker can save you a lot of time and help you understand which type of valuation is best for you.
1. The Asset Approach
Commonly known as the “cost approach,” the asset approach determines the fair market value of a business based on the value of its assets minus its liabilities. The asset approach aims to calculate the net asset value or net worth of the business. The commonly used valuations under this approach that determine the value of your business assets are:
2. The Market Approach
The market approach develops the value of a business based on comparing historical sales prices of companies in the same industry to markets with similar characteristics. Business brokers and valuation professionals use a variety of databases and services that record business sales to evaluate a specific business and to find their true market value.
3. The Income Approach
Also known as present value and income, the income approach focuses on today’s dollars and your anticipated business based on future economic events.
The focus of this method is to determine the value of a business based on its ability to generate a desired economic benefit or income for the owner(s). The seller’s discretionary cash flow, or net cash flow, is then capitalized, modified, or multiplied to assess the valuation properly.
To ensure the income-based approach is executed successfully, selecting the right discount rate, valuation multiples, and capitalization rate is critical. The most common methods to determine a business’s income value are:
- Capitalization of earnings approach
- Discounted cash flow approach
- Multiple of discretionary earning approach
The Best Valuation Method for Small Businesses
When buying a business, the buyer is ultimately purchasing the future income stream of a business. So intuitively, the income approach may seem to be the best methodology. However, the predictability of the future income can be very volatile in smaller businesses, so the income approach is more widely accepted for larger and more stable businesses.
For smaller businesses, the market approach is usually the most relevant methodology. However, all three methodologies are often looked at and the valuation will utilize the best approach, or combination of approaches, based on the relevance to the business itself.
The Best Valuation Method for Franchises
The valuation method for a franchise should not be any different. However, a robust franchise system will often develop a “rule of thumb” of what their franchise sells for. This is a formula based on the average sale prices of their franchise over time. For larger and very successful franchise systems, they often demand a premium over like businesses that don’t have the brand recognition and strong franchise system behind them. Ultimately, all the methodologies are being used (market, income, and asset) and will need to support the “rule of thumb” for the valuation to be justified.
Each business is unique. To determine which business valuation method suits your business best, consult the nearest Sunbelt Business Brokers today.
