There are three business valuation approaches or methods:
The Asset Approaches are where the individual assets of the business are valued as if they were being sold.
The Market Approaches are where comparable market sales are used to estimate a value of the company.
The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value.
More detail below:
The Asset Approaches are where the individual assets of the business are valued as if they were being sold. This is usually used for non-performing businesses that may be liquidated.
The Market Approaches are where comparable market sales are used to estimate a value of the company. The formula is the cash flow times the multiplier equals the value (or $100,000 cash flow x 2.2 multiplier = $220,000 value). The multiplier is developed by looking at the sales price of the comparable sales data usually obtained from reporting services and dividing it by the cash flow. (Multiplier = Price / Cash Flow or $100,000 price / $50,000 cash flow = a multiplier of 2.) For very small businesses these comparable businesses may be mainly owner operated businesses.
When reviewing the various market methods a major concern is the comparability of the selected comparable companies to the company being valued. Are they similar or very different? In addition the valuator needs to make reasonable adjustments for overall risk of the company being valued vs. the comparable set. For instance a company with two clients each at 50% is much more financially risky all things being equal than a company with 100 1% revenue clients. The multiplier should be adjusted to reflect company risk vs. the likely risk in the comparable set.
The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value. Public market data is used to develop a discount rate. The discount rate is divided (along with present value adjustments) into a projected cash flow in the discounted cash flow income method. This is a quite complex formula. A more commonly used income method with small businesses is the capitalization of earnings method. In this method a capitalization rate which is a discount rate minus a growth rate is applied to historic earnings adjusted by the growth rate for the next year (selected historic cash flow of $100,000 and a 3% growth rate = $103,000 adjusted cash flow / .25 (a discount rate of .28 – .03 growth) = $412,000 value). Discount rates are generally developed for very small businesses using the build-up method (also called the BUM). In short, the cost of capital for different layers of business risk has been calculated looking primarily to public companies and public information.
Each layer of a build-up should be carefully reviewed to make sure it was developed correctly as of the proper valuation date. The last layer in the buildup method is specific company risk which is valuator judgement where all of the specific strengths and weaknesses of the business are accounted for that may impact Risk. Note that Risk for business valuators is the perceived likelihood that future cash flows will not be met.
In all cases there is tremendous judgment in estimating a multiplier, discount or capitalization rate. Which method to use depends on the facts in the case and the available data. For smaller and micro businesses (I define as usually under $10 M revenues) there often is quite a large amount of market data which should favor using that method. For businesses over $10 M in revenues there may not be enough relevant data to use the market method. Then the income method is likely to be the best method. Remember, methods are models and none are perfect. We must select the best method based on all factors. That, is professional judgment at work.
In all cases, use common sense. Make sure the selected value ties into the risk (and has some relationship to a price someone would pay) of the company including likely economic, industry, and other foreseeable changes in the future.
Greg Caruso, JD, CPA, CVA, the author of “The Art of Business Valuation, Accurately Valuing a Small Business” 2020 published by Wiley is always available to prepare (or review) business valuations for all purposes and situations. gcaruso@harvestbusiness.com