Income Approach - Asset Approach - Market Approach
Over the course of my last twelve columns, I have focused on several topics to help a new CEO start a new business. Recently, I have gotten questions from CEOs who are looking into some major transitions for their existing business and they are wanting me to do an article about how best to come up with a value on their small business.
There are several pivotal times during the life of your business at which you will want to know the true or fair market value of your own company, or the value of another entity. These circumstances may include buying an existing business, selling a business, merging with another business, going public, taking on private investors or passing on a business to any heir in an estate or as a gift.
When you are in one of these situations, you will want to determine exactly how much the business in question is worth. Essentially, how much can it command on the open market. The fair market value of an entity is typically defined as the amount at which the property would change hands between a buyer and a seller when neither of them is under the compulsion to buy and when they both have reasonable knowledge of relevant facts concerning the business. But what are those relevant facts and how can you go about assessing them to achieve the fair market value.
I will use several sources that SCORE provides on this topic to write this article. For the purpose of illustration, let’s start from a blank slate and assume you are trying to value your existing business. How do you begin to know what the company is worth?
Even if you know your key figures, such as sales, gross revenue and profitability, and you can estimate its growth potential, you still may have many missing blanks to fill in when it comes to knowing that business’ true value. Generally there are three methods for valuing a business.
The income approach to valuation is used to determine potential future income and is typically appropriate when evaluating small closely held businesses that are not asset intensive. Basically, this method is based on the premise that a business’ value is intrinsically tied to the present value of income it can generate in the future. It estimates future cash flow then discounts it using a capitalization rate which is a percentage used to convert income into present value.
The key to using this approach correctly is finding the proper capitalization rate that will reflect both the riskiness associated with your business or industry and the uncertainty of its future cash flow. You can research the internet and trade publications for those that are appropriate for your industry and business size.
For this illustration, I will use a conservative rate of 25%. Let’s assume you own a small retail operation. We will say that the business has projected sales of $500,000. To find the fair market value, it is then necessary to divide that figure by the capitalization rate. Therefore, the income approach would reveal the following calculations. Projected sales are $500,000, capitalization rate is 25%, so the fair market value is $125,000.
The asset approach to valuation may be the most straightforward method because it is based directly on the value of a company’s assets less any liabilities it has incurred. It takes into consideration, not only tangible assets, meaning equipment, furniture, inventory and so on, but also intangible assets that constitute good will and provide economic returns to the company, including name, reputation, customer patronage, location and the like.
It’s appropriate to use this method when the business’ profits are small in comparison to the assets used to generate them. Let’s use the same example of a small retail shop and conduct an asset evaluation to make sure that the value arrived at using the income approach is greater than the value of the assets owned by the business. If it is not, the asset approach would be more appropriate in determining the value of this company and its profits would not justify the business’ investment in the assets it owns.
The market approach is a way to determine the value of a business by comparing the business to similar public companies that have been recently sold. If you decide to use this approach, you can start by consulting the following sources for comparative information: the internet, SIC numbers, trade associations, and trade journals. Once you find similar companies, be sure to check out how they compare with your business in terms of how long being in business, how similar is the customer base, how similar are the risk factors, and how similar is the level of profitability.
Now that you have become familiar with the various approaches to valuation, you can decide whether it is a task you and your team feel comfortable tackling on your own, or whether you would rather enlist the help of a professional. You can find appraisers who specialize in your geographic area and industry by doing a simple web search or speaking to your current financial or legal advisors for recommendations.
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