While there isn’t a universally accepted gold standard for business valuation, there exist several widely employed methods, metrics, and market factors that sellers should take into account when assessing the value of their business. Professionals typically rely on three fundamental approaches to business valuation: income-based, market-based, and asset-based valuation. Each of these approaches offers distinct advantages and considerations.
Income valuation methods utilize the current income of the business to determine the sale price
The final sale price agreed upon between the buyer and seller might not be directly correlated to these business valuation tools they are still useful tools that can provide the parties with useful benchmarks, and a reference point for the buyer and seller during the negotiation process.
Income valuation provides a useful, but imperfect approach to creating value to a company. The approach doesn’t always work in the context of an employee-owned company. Because cooperatives assume that the buyer is looking at purchasing the business as a source of investment income. Nonetheless, it can provide sellers seeking to convert their business to employee ownership with a reasonable benchmark of valuation used by many businesses.
The buyer can also use this as a way to reduce the value of the business. For example, if they know the seller has a much lower expected rate of return ( below 10%). This could be used in negotiations with the employee committee and the seller.
There are two basic approaches to income valuation:
1. Discounted cash flow /Discounting method
- Using the discounting method is when an appraiser would estimate the value of the investment based on its expected future cash flow. It attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future.
- The main benefit of using the discounting method is that it accounts for the time value of money. This could potentially be beneficial for a buyer’s committee that is weighing the possibility of purchasing the business and wishes to determine whether the purchase of the business would make economic sense.
- Income valuation approaches are likely less applicable in the cooperative conversion context. This may be particularly true of the discounting method because the long-term investment is each member’s investment and this might change drastically over time.
2. Capitalization method
- The capitalization approach is expressed by the formula:
- Business Value x Desired Rate of Return = Expected Annual Profits.
- First, the seller must identify a target annual rate of return that they expect would be attractive to a buyer (typically between 10% and 20%). The seller must then identify, with reasonable accuracy, the business’s profits for the next few years. After determining the annual profit, the seller divides this number by the desired rate of return. The resulting value would be the business’ sale price.
- Example of Capitalization Method:
- A Seller who reasonably anticipates that an investment-oriented buyer would want a 20% annual return, and reasonably anticipates that the average annual profit over the next few years will be $50,000, would divide $50,000 by .2, for a business valuation of $250,000.
- The capitalization approach is expressed by the formula:
Comparing the business to others in the industry
The market method involves assessing the value of a business by comparing it to similar companies in the market. There are three common ways people do this:
- Guideline Public Company Method
- This method seeks to find public companies engaged in a similar business as the private company being sold in order to find a potential free-market value of the equity.
- This method is a bit more complicated than the other market methods and will likely require the assistance of a business appraiser. Furthermore, it is probably not applicable to most small companies and should be limited to companies with annual revenues exceeding $5 million. Nonetheless, it can provide useful information for sellers, buyers’ committees, and their attorneys in assessing the potential value of the company.
- Sale of Comparable Businesses Method
- Ideally, a seller will look to market data on the sale of similar businesses to inform the ultimate sale price. This data, however, is not abundant and requires significant investment in time, and perhaps money, to obtain. Nonetheless, acquiring such data can be a great resource in providing the buyer with a reasonable estimate of what the business is worth.
- Resources for data on the sale of comparable businesses include
- Trade publications
- Business brokers
- Business Valuation Resources
- BizComp Service
- Personal networks
- Industry Formulas and Standards
- Some industries have developed formulas that are commonly used to estimate the value of a business. However, it’s important to remember that these formulas are not precise and may not consider specific factors that affect the seller’s unique business.
- Here are a few examples of such formulas:
- Sales or Earnings Formulas: These formulas multiply the gross sales or net earnings of the business by a certain multiplier to determine its value. For instance, a business might be valued at five times its annual gross sales or net earnings.
- Units Formulas: These formulas use a multiplier multiplied by the number of customer contracts in place or the number of machines in operation to assess the value of the business.
Valuing the business based on its assets
Another way to determine the value of a business is by considering the potential resale value of its physical assets and the worth of intangible assets like leases, business name, intellectual property, and customer lists. It’s important to note that the value of a company’s assets should not be confused with its book value, which is an accounting term that might not accurately represent the true overall value of the assets due to factors like asset depreciation.
When valuing a business based on its assets, it’s crucial to consider any outstanding or potential liabilities. These liabilities can affect the asset valuation unless the seller agrees to take sole responsibility for them. This means that the value of the assets may be affected by any existing or possible debts or obligations associated with the business.
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