Business Valuation Basics

Business Valuation Basics

Posted on August 10, 2017

Accurately valuing a business is the foundation to any acquisition.  It can be one of the most difficult tasks for both a buyer and a seller.  There are a lot of "rules of thumb" methods for just about every industry.  Valuation experts use technical methods including discounted cash flow, multiple of seller's discretionary earnings, comparative transactions, asset based, etc.  However it doesn't have to be an overwhelming task.  If you apply some common sense you will be able to make sense of the process.

The value of most businesses comes down to one thing: the amount of money the business will produce in the future.  For large companies, a very complex process is used to predict future earnings.  For small and medium-sized businesses, it's too difficult and risky to predict the future, so we assume that past performance is the best indicator of what the future will bring.  So when we say that the value of your business is 3 times your SDE (Seller's Discretionary Earnings), we are assuming that your past earnings will continue into the future. 

Common Valuation Methods

(1) Adjusted Net Asset Approach:  With this business valuation approach, value is determined based on the market value of the underlying assets.  The valuation analyst starts with the book value basis balance sheet and revalues all assets and liabilities to fair market value.  The process may require obtaining appraisals for real estate, equipment, and personal property.

(2) Income Approach:  The business value is determined by measuring the anticipated future income.  This approach utilizes net income and seller discretionary earnings - specifically the present value and capitalization of income.

(3) Market Approach: The business value is determined by analyzing similar entities traded.  For public markets, the approach relies on publicly traded stock, and for private markets it relies on private sales databases.  The business valuation analyst then relates FMV transactions to the subject company.

Factors for Discounts and Premiums

Another important consideration of a business valuation is whether any discounts or premiums apply.  When considering the FMV of a company the company is viewed in its entirety.  A skilled M&A professional can add to a company's value by identifying premiums and correcting discounts.  Common discounts and premiums typically include:

  • Minority interest / lack of control (-)
  • Lack of marketability (-)
  • Dependent on key person (-)
  • Customer concentration (-)
  • Litigation (-)
  • Recurring revenue (+)
  • Consumable products (+)
  • Growing industry (+)

We have just touch on the basics of business valuation.  It's very important to have a professional value your business before taking it to market.  At IEB, we offer a free Opinion of Value Letter that will give you a idea of market value.