Question

For this week's Discussion:

• Briefly explain business valuation and its purpose (also referred to as company valuation). Select a valuation method from the introduction in the Learning Guide and describe why you might use that method to value a business.

Answer 1

Business Valuation Definition

Business valuation is the process of determining the economic value of a business or company. It assesses a variety of factors to determine the fair market value in a sale, but there is no one way to verify the worth of a company. Business valuation can depend on the values of the assessor, tangible and intangible assets, and varying economic conditions. Business valuation provides an expected price of sale; however, the real price of sale can very.

Traditional approaches to business valuation employ financial statements, cash flow models, and comparisons to competitive companies within a similar field or industry.

Business Valuation Methods

Income Approach: determines business value based on income. This type of valuation focuses on net cash flow, discretionary cash flow, and capitalization of earnings.

Asset Approach: determines business value based on assets. This type of valuation focuses on both asset accumulation (assets minus liabilities) and capitalized excess earnings.

Market Approach: determines business value in relation to similar companies. This type of valuation focuses on the comparative transaction method and appraises competitive sales of comparable businesses to estimate economic performance looking at revenue or profits primarily.

Business Valuation Purposes

Although the primary purpose of business valuation is preparing a company for sale, there are many purposes. The following are a few examples:

Shareholder Disputes: sometimes a breakup of the company is in the shareholder’s best interests. This could also include transfers of shares from shareholders who are withdrawing.

Estate and Gift: a valuation would need to be done prior to estate planning or a gifting of interests or after the death of an owner. This is also required by the IRS for Charitable donations.

Divorce: when a divorce occurs, a division of assets and business interests is needed.

Mergers, Acquisitions, and Sales: valuation is necessary to negotiate a merger, acquisition, or sale, so the interested parties can obtain the best fair market price.

Buy-Sell Agreements: this typically involves a transfer of equity between partners or shareholders.

Financing: have a business appraisal before obtaining a loan, so the banks can validate their investment.

Purchase price allocation: this involves reporting the company’s assets and liabilities to identify tangible and intangible assets.

Three Business Valuation Methods

When determining the value of a company, there are three ways to evaluate worth:

• Asset-based approaches
• Earning value approaches
• Market value approaches1

Each approach has its considerations, and if you own a sole proprietorship there are further factors to consider.

Asset-Based Approaches

Essentially, an asset-based business valuation will total up all the investments in the company. Asset-based business valuations can be done in one of two ways:

• A going concern asset-based approach takes a look at the company's balance sheet, lists the business's total assets, and subtracts its total liabilities. This is also called book value.
• A liquidation asset-based approach determines the liquidation value, or the net cash that would be received if all assets were sold and liabilities paid off.

Asset-based Valuations of Sole Proprietorships

Using the asset-based approach to value a sole proprietorship is more difficult. In a corporation, all assets are owned by the company and would normally be included in the sale of the business. Assets in a sole proprietorship, on the other hand, exist in the name of the owner, and separating business assets from personal ones can be difficult.

For instance, a sole proprietor in a lawn care business may own various pieces of lawn care equipment for both business and personal use. A potential purchaser of the business would need to sort out which assets the owner intends to sell as part of the business.

Earning Value Approaches

An earning value approach is based on the idea that a business's value lies in its ability to produce wealth in the future.

• Capitalizing Past Earning determines an expected level of cash flow for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
• Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.

Earning-Based Valuations of Sole Proprietorships

Valuation of a sole proprietorship in terms of past earnings can be tricky, as customer loyalty is directly tied to the identity of the business owner. Whether the business involves plumbing or management consulting, the question is: Will existing customers automatically expect that a new owner will deliver the same degree of service and professionalism?

Any valuation of a service-oriented sole proprietorship needs to involve an estimate of the percentage of business that might be lost under a change of ownership.

Market Value Approach

Market value approaches to business valuation attempt to establish the value of your business by comparing your company to similar ones that have recently sold. The idea is similar to using real estate comps, or comparables, to value a house. This method only works well if there are a sufficient number of similar businesses to compare.

Market-Based Valuations of Sole Proprietorships

Assigning a value to a sole proprietorship based on market value is particularly difficult. By definition,​ sole proprietorships are individually owned, so attempting to find public information on prior sales of similar businesses is not an easy task.

The Best Choice May Be a Combination

Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price. The first step is to hire a professional Business Valuator; she will be able to advise you on the best method or methods to use to set your price so you can successfully sell your business.