Value a Business
There are three basic methods of valuing a business:
Simply stated, the asset approach values the assets of the business. The value of the assets of a business are, however, not always easy to ascertain. For example, the value of the assets as stated
on the balance sheet – “book value” – is almost always not the true value of the assets in the marketplace. If a business is being liquidated and the assets must be sold by next Friday, then the book value is not of importance. However, if the assets can be sold over a course of several months, then the value of these assets is closer to their fair market value (FMV). Most of the time, assets are valued at FMV, defined as the price that a reasonable buyer would pay a reasonable seller when neither were under pressure to buy or sell. Unless you are buying a business that is very asset intensive, marginally profitable, or losing money, the asset approach usually is not the best indicator of the true value of the business.
The income approach uses one or more methods to determine the value based upon the anticipated benefits of business ownership. Simply stated, the income approach determines the value of the anticipated stream of business income. Although entire books have been written on the subject, the most relevant discussion revolves around what are the earnings and what is the discount rate or capitalization rate applied to the earnings? Earnings, as discussed elsewhere, are the adjusted profits of the business.
Most professional valuations use one of two types of earnings:
- SDE, or seller’s discretionary earnings, is a direct measurement of the true bottom-line benefit of owning a business. SDE includes the owner’s salary or take-home compensation.
- EBITDA, or earnings before interest, taxes, depreciation and amortization, differs from SDE in one key area: it includes compensation for management. Discount or capitalization rate can vary greatly by the type of prospective purchaser and the overall risk of the continuity of the income stream. Depending on the buyer and the business, some potential areas of risk can be the size of the company, competitive forces, barriers to entry, growth rates, lack of management, etc. As a broad-brush example of risk, an investor investing in a portfolio of stocks representing the entire stock market may believe that an 8% rate of return is adequate given the enormous diversification in industry and given that these publicly held companies have top quality management. On the other hand, a potential buyer of a beauty salon may seek a 50% rate of return given the large number of competitors, high employee turnover, low barrier to entry, and the necessity of constant supervision.
The market approach determines the value of a business by comparing it to similar businesses that have been sold. Although not as complete or comprehensive as residential comparable sales, there are several very good databases of sold businesses. Businesses are seldom exactly the same, but grouping like businesses by type and or region make comparisons relevant. VR subscribes to these databases and often checks numerous sources to find like businesses. VR also has extensive comparable sales for similar businesses sold throughout their broker network. Ratios considered when using the market approach are the price to earnings and price revenue.
Our VR office will offer simple, limited business valuations free of charge, but we recommend that most sellers invest in more sophisticated in-house or third party valuations that develop more precise recommendations regarding selling price. There is nothing more important in the selling of your business than to do this accurately.
Opinion of Value - Prepared In-House
This limited scope appraisal generally uses only the market data method to determine the approximate value of a going concern. This method utilizes comparable sales data from thousands of transactions reported nationwide in proprietary databases to which we subscribe. In some cases where business are growing or generating more than $500,000 of EBITDA, this report will also include the income method to determine valuation. It is excellent for getting an approximation of the fair market value of an ongoing business and is prepared in-house. The turnaround time for this report is 3-5 days after receipt of all necessary documentation.
Value Analysis - Prepared by a Third Party Valuation Firm
This is a limited scope third party analysis that uses the income approach, the asset approach, and the market data approach to determine the fair market value of the business. This report is intended to establish the value of 'Main Street’ businesses with revenues under $1,000,000 or in slightly larger businesses that are relatively straight forward. The report is approximately 40 pages and the turnaround time is 14 days after receipt of all documentation. The report provides a summary of how the valuation conclusion was determined. Since most 'Main Street' businesses are bought and sold on a multiple of cash flow, the basis of this valuation is Seller’s Discretionary Earnings (SDE). The analysis considers primarily historical and current financial performance and very little time is spent with the balance sheet. The report contains the following:
- Historical Income Statement
- Adjusted Cash Flow Statement (SDE)
- Comparable Sales (Market Approach)
- Summary of Common Size Financial Statistics
- Summary Review of Each Valuation Approach
- Valuation Conclusion and Justification
Formal Valuation - Prepared by a Third Party Valuation Firm
The Formal Valuation is a limited scope business valuation intended for the standard small business with sales between $1,000,000 and $5,000,000. The report is approximately 50 – 70 pages, takes about 14 days to complete and provides detailed review of all aspects that were considered in determining the final valuation conclusion. The bulk of the report is financial analysis and the valuation conclusion is based more on EBITDA rather than SDE and spends more time on current and future financial performance of the company. In addition to the earnings of the company, the Balance Sheet is also a key component of the analysis. The report contains the following:
- Historical Income Statement
- Adjusted Cash Flow Statement (SDE)
- Complete Financial Statement Analysis
- Common Size Analysis
- Ratio Analysis
- Economic Outlook Comparable Sales Detailed Description of Each Valuation Approach Considered & Used
- Valuation Conclusion
Merger & Acquisition Valuation - Prepared by a Third Party Valuation Firm
The Merger & Acquisition Valuation is a comprehensive business valuation for transactional purposes and is developed in accordance with the Uniform Standards of Professional Appraisal Practice. This valuation is intended for the larger small business with annual revenues in excess of $5,000,000, businesses that are expected to sell for more than $1,000,000, strategic acquisitions of niche businesses, and generally any business with significant growth expected in the future. The basis of the valuation is future earnings with the historical performance playing only a limited role in the valuation conclusion. The selection of guideline companies comes from both the private and public markets, which tends to make the valuation conclusion more aggressive. This report is a completely customized, is approximately 80 pages in length and takes about 3 – 6 weeks to produce.