Determining the value of a business should be the first and foremost step in buying or selling a business.
The value of a business is related to the risks involved in operating it and the future ability of the business to generate cash flow to the owner (cash flow is calculated from an economic viewpoint, rather than from a tax or an accounting perspective). The value of the underlying hard, tangible assets as well as intangible assets must also be considered.
The valuation process involves extensive research, financial analysis, and consideration of the elements that drive the value of the business.
Value of the hard, tangible assets.
Amount of re-casted cash flow (under a normalized earnings scenario)
Value of the intangible assets (licenses, trademarks, proprietary information, patents, client base, brand, etc.)
Application of industry and/or company-specific discounts or premiums
Three Approaches to Valuing a Business
The Cost/Asset Approach is based upon the value of the assets net of related liabilities. It takes into consideration the Book Value of the assets. Using this approach in isolation rarely yields a true indication of market value.
The Income/Earnings Approach values the business based on an expected stream of earnings or cash flow capitalized by a risk-adjusted rate of return. It is used primarily to value businesses when it appears that a company’s current operations can reasonably be considered indicative of its future operations.
The Market Approach emphasizes the principle of substitution, which means that given alternative investments, a buyer would be expected to gravitate toward the investment with the lowest price if all other attributes (risks, return on investment, etc.) are the same.
Within each of these three major approaches are several modified methods. A professional valuation takes into account multiple methodologies to arrive at the final valuation. Valuation of a business is both science and art.
If there are several similar companies available in the marketplace, it is likely that some pricing comparisons may be drawn; though comparisons are often difficult to make because there are so many characteristics of a business which can add to or detract from its value. Unless a buyer is able to definitively study several very similar companies, the buyer may draw incorrect assumptions about their price comparisons.
The Final Test
Within each of these three major approaches are several modified methods. A professional valuation takes into account multiple methodologies to arrive at the final valuation. Valuation of a business is both science and art.
If there are several similar companies available in the marketplace, it is likely that some pricing comparisons may be drawn; though comparisons are often difficult to make because there are so many characteristics of a business which can add to or detract from its value. Unless a buyer is able to definitively study several very similar companies, the buyer may draw incorrect assumptions about their price comparisons.
Will cash flow cover the debt service of the buyout financing?
Will cash flow provide a reasonable salary to the new buyer?
Will cash flow provide for future replacement of equipment and for a cushion of safety during the fluctuations of the business cycle?
