When the time comes to sell a business there are many considerations and steps which need to be taken. Outside of the comprehensive preparation process, designed to increase the value of a potential deal, a business valuation provides important insight into the current value of an enterprise. A business appraisal provides a formal assessment of a company’s value in current market conditions. The process of conducting a valuation is dependent on many factors including the type of business, industry focus, and more. For this reason, a valuation professional can choose from several methods. The primary methods include the income, asset, and market approaches. Since the method used can impact the resulting value, it is important to become familiar with the details of each. To help clients, prospects, and others, WhippleWood CPAs has provided a summary of the key details below.
Comparison of Business Valuation Approaches
Income Approach
The income approach is concerned with the future earning potential. Considerations involved in the income approach can include expected cash flow and discounting them to the present value
- Discounted Cash Flow Analysis – A discounted cash flow analysis (DCF) projects future cash flows over several years and discounts these projections to the present value using a discount rate that reflects the risk level associated with a future investment in the business.
- Capitalization of Earnings – This divide what the company is currently earning by a capitalization rate to reach the present value. The capitalization rate reflects the risk and return that can be expected with the planned business investment.
This can be an appropriate approach for businesses that have stable earnings and growth prospects that aren’t expected to change in unpredictable ways. Companies that belong to volatile industries or those involved in emerging technologies and business approaches may not be accurately portrayed through an income approach.
Asset Approach
The asset approach values a business based on the value of the intangible and tangible assets included in a business.
For this approach to be the most effective, businesses need to consider all tangible assets and intangible assets alongside liabilities to calculate a solid net asset value. All property, equipment, and inventory should be included in tangible assets. Intangible assets can include trademarks, copyrights, patents, and other intellectual property. Liabilities include any debts and obligations measured by the book value on balance sheets.
If a business has significant assets, this approach can be useful. Organizations going through liquidation may also choose this method. Using an asset approach can be less accurate for businesses that have more significant intangible value – for example, the value lies in customer relationships or established reputation.
Market Approach
Finally, the market approach compares the organization with other similar businesses that have been sold recently to derive comparative value. A comparable company analysis identifies publicly traded companies that are similar to the business being assessed and compares the company’s financial metrics to these examples to create a valuation multiple. Similarities between these companies can include size, industry, and potential for growth. Businesses can also perform a precedent transaction analysis, comparing the sales price of recently acquired companies to determine the valuation multiple.
If there are comparable businesses that have recently sold and have compelling parallels that can be made with the business being valued, this can be an easy way to establish a good baseline. However, if market data is inaccurate or not quite the right fit, this may provide an inaccurate value.
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Determining which approach is most appropriate for a business depends on which businesses are in the market, the type and amount of assets, and how predictable the growth has been. Understanding the idiosyncrasies of a company and specific business goals can make it easier to pinpoint the right approach.
If you have questions about the information outlined above or need assistance with a business valuation, WhippleWood CPAs can help. For additional information call 303-989-7600 or click here to contact us. We look forward to speaking with you soon.