Methods of Business Valuation

Adjusted Net Asset Method

The asset value method is used to determine a minimum value range for a business. That value represents the estimated worth of all tangible and intangible assets. In this method you determine the fair market value of the assets in a business, which includes installation and testing costs. You then take this and subtract the liabilities to determine the business value. Fair Market Value - Liabilities = Business Value

Capitalization of Earnings Method

This method, like all other income based methods is based on the economic theory that the whole is more valuable than the sum of the parts. You look at a company’s future earnings, as that is what someone is purchasing. In this process you need to identify all unnecessary assets and liabilities and remove them from the income statement to give yourself the correct numbers to introduce to the equation. The equation ____ is a basic formula developed by Dr. Shannon Pratt and stated in the book “Valuing Small Businesses and Professional Practices” (McGraw-Hill, 1998). The formula is as follows:

Present Value = Expected Economic Income Direct Capitalization Rate

Debt Capacity Method

This method of valuation is purely a financial model. Direct cash expenses are deducted from direct cash revenues to determine discretionary cash flow. Deductions are then made for an operator’s salary and the real depreciation cost of assets. The result is discretionary cash for debt service. The maximum debt service this business could handle, given the current level of discretionary cash, is calculated based on the number of years financed, and an interest rate.

Discounted Cash Flow Method

This method is based on discounting the forecasted earnings or cash flow stream at a risk-adjusted rate of return. The earnings stream is forecasted for ten years and a terminal value is calculated at the end of ten years. The terminal value is calculated by capitalizing the last period’s earnings and then discounting the result to its present value.

Comparable Sales Method

This method is based on comparing the business being valued with similar businesses that have been previously sold. Since revenue numbers are usually more accurate than net income numbers, you would calculate a weighted intangible price to revenue ratio, based on previous business sales, and then calculate an intangible value to which you would add back this company’s assets to arrive at a total value.

National Method

This method is based on a series of factors. In spite of oversimplification and the inability of these factors to shift with changing economic conditions, these formulas would be included because they are routinely used by a buyer in evaluating a purchase. The following factors have been taken into consideration:

  1. Finance Years - This factor assumes the greater the loan period, the more a buyer will pay.
  2. Financing Rate - This factor considers interest rates and types. It decreases the amount payable to a seller as the cost of financing increases.
  3. Consulting Times - This factor pays for education time from a seller.
  4. Net Cash - The greater a business’s discretionary cash, the more a buyer should be willing to pay.
  5. Years in Operation - This factor assumes each year of past survival indicates a greater chance of future survival.
  6. Employees - This factor decreases value for a greater number of employees, as having a larger work force can create greater labor problems.
  7. Local Economy - A better economy provides more certainty of future success, giving the business a higher value.
  8. Local Market - This factor assumes labor is a major business cost. If the labor market is soft for this business, labor cost will not rise; the converse is also true. The following have a direct effect on the labor market and therefore on the business value: union strength, age of industry, national economy, and industry market . This factor also assumes that if a business requires high level skills, it poses a higher risk and, therefore, is worth less to a potential buyer.
  9. Union Strength - This factor analyzes how an outside organization can control your business. The less control a business has over its labor force, the less a potential buyer is willing to pay.
  10. Age of Industry - This factor increases value for stability and longevity in proportion to an industry’s age.
  11. National Economy - This factor assumes a growing economy increases a business’s demand and price. Conversely, a declining economy decreases demand for a particular business and its price.
  12. Industry Market - This factor looks at the future markets for the products or services of this company and industry. The security or risk assigned to the future will directly raise or lower any suggested price.

Weighted Factor

This method assumes that the business value is based on the highest potential value of assets plus the discretionary cash flow multiplied by a factor, which is based on the learning curve for this type of business. The current demand for this industry and business are also taken into account. The business value represents the maximum possible price a buyer would pay given a business at this scale of operations and profit level. Each factor adds or deducts from the target value to arrive at a suggested price. Each of the following factors has an affect on the final suggested price:

  1. Labor - This factor weighs the stability of a company’s labor force and the changes, which may reduce profits under a new owner.
  2. Predictability - This factor reviews the company’s historical and current trends compared to the local and national economic trends.
  3. Management - This factor estimates the integrity of the current management system and how changes of ownership will impact the business.
  4. Competition - This factor weighs the possibility of a new owner going out of business because of a saturated market.
  5. Revenues - The past and present problems of collecting revenues will probably remain unchanged under new ownership.
  6. Longevity - The number of years a business entity has survived and grown is usually proportional to the confidence level for future survival. This factor balances lease rates, years at this location, and the utility of this location for this business against current and potential competitive locations.
  7. Loan Ability - This factor weighs this company’s ability, based on its own assets, to acquire funding from lenders.
  8. Clientele - This factor weighs the stability of clients and future expectations for revenue from those clients after a management change.
  9. Liability - This factor weighs the hazard level of this business and how easily a bankruptcy situation could occur.