How is a business valuation frequently used? A business valuation plays an important part in an owners estate planning or business exit & succession plan, it helps businesses qualify for loans, a valuation is also needed to sell a business, just to name a few. And often, it is the business owner that takes it upon themselves to arrive at a value of their business. This makes sense to since they feel that they know their company best, their operations, financials and all parts of the business extremely well. If they can’t do it themselves, owners frequently ask an internal department or a company accountant for help in valuing a business. There are many different business valuation models available.
While it is possible for a business owner and their staff to attempt the valuation of a business it’s important to seek out professional assistance by enlisting the services of a Business Valuation Expert with Certified Business Intermediary (Mergers & Acquisitions) credentials.
Why is this so important? Because there are elements of a business valuation reports that owners, accountants and valuation specialist cannot and do not include in their business valuation report. A marginal business valuation will be to the advantage of second parties, they will be able to shoot holes through a poorly constructed valuation and be able to chip away at the price. Because subjectivity is a part of a business valuation it needs to be constructed in a proper way to defend subjective parts, so building defensible and very strong elements necessary to support the final value cannot be overstated.
There are many intelligent, well-educated business owners and professionals who may downplay the need to and still use valuation reports that are not produced by a Business Valuation Expert with Certified Business Intermediary (Mergers & Acquisitions) credentials. Take a moment to consider the complexity that goes into a quality valuation, one that others can’t poke holes through. Below are brief descriptions of six business valuation models used to determine the value of a business. In a comprehensive business valuation, all six business valuation models should be considered to arrive at a final value. No matter the argument one might make to reduce a business’s value, a credible business valuation will support and defend any challenge. The following are summaries of the six business valuation models.
Comparable Price Valuation Model
The comparable price valuation model uses (at a minimum) three comparable businesses that were sold in an open market. Once these businesses have been determined, the net income, cash flow, EBITDA, and Price/Earnings ratio are used to compute the benchmark value. This information will help produce an industry reference benchmark which will be used to determine an appropriate multiple for computing a business value.
Capitalization of Earnings Valuation Model
Business valuation services experts agree that the capitalization of earnings is the most important factor in the business valuation of most operating companies such as manufacturers, merchandisers, and companies providing services. At the end of the life of a company, the total worth of that company can be found in the ability it had to generate earnings. This knowledge is the basis for the capitalization of earnings valuation model which uses historical data to project future earnings. The method goes back through five years of financials and projects future earnings potential for up to five years using growth rate, present value, and expected earnings figures.
Adjusted Book Value (Net Tangible Assets) Valuation Model
This business valuation method, also referred to as the underlying asset value method, is especially useful in valuing holding companies such as investment houses and real estate companies. This method is also useful for liquidation purposes because it provides the “adjusted” asset value which relates to the fair market value of assets. Some have also preferred this method in valuing capital intensive businesses that rely on their asset base to perform work and generate income. An excellent example of this is a construction company. The company’s machinery is vital to their operations. This concept can be contrasted with a law practice whose income generating ability does not rest on physical assets of the firm but, rather, on it’s employees. The key to this method is determining the fair market value of all useful assets versus the value as stated on the books of the company.
Excess Earnings Capacity Valuation Model
This business valuation method is based on the theory that the value of a company is equal to the value of the net tangible assets plus the value of excess earnings (e.g.., goodwill, patents, trademarks, copyrights, etc.). Unlike patents or trademarks, the term “goodwill” is rather vague and could be overlooked by an inexperienced valuation company.. Eight factors are typically considered when calculating goodwill: age of the company, employee turnover, the value of the suppliers and the products sold, market area, potential growth, inventory efficiency, company location, and banking relationships. Excess earnings attributable to intangible assets are the foundation of the value of goodwill. Once this calculation is made, the result is added to the adjusted asset value as determined above.
Present Value of Future Income Stream Valuation Model
A variation of the capitalization of earnings method, the present value of future income stream valuation model is also referred to as the “Leveraged Debt Concept.” This concept takes into consideration the fact that an outside party may leverage an acquisition of the current company and use all of the income to pay the interest on borrowed money. Currently the cash flow method is becoming more relevant in a valuation as companies tend to “free cash”.
Net Income Residual Approach Valuation Model
Effectively, this valuation model determines the ability of a company to pay dividends to the stockholders using income that is not needed to operate the business in the future. Dividends are based on earnings after taxes as they relate to investment (stockholder’s equity) at the beginning of the fiscal year and are distributed to stockholders instead of being kept in retained earnings to help finance future projects. This is a key method used to determine what an investor would pay for participating in the operations of a privately held company.
Six business valuation models of “how to value a privately held business“ have been presented in a summary manner. Each method has different advantages and disadvantages as well as application to certain types of business valuation requirements. The business valuation services experts will determine which methods are most appropriate for given circumstances and business valuation standards.
For more information about business valuation reports and information on business valuations contact one of our Advisors at 502-244-0480
Posted by Brian s. Mazar, CBI, MBA