Valuation: Getting the Right Price Valuation Approaches and
Methods
When Selling Your Business
Income Approach
The Income Approach involves valuation
methods that convert future anticipated
Although considerable time and effort is involved in preparing formal business economic benefits (e.g., cash flow) into a
valuations, unfortunately the results may or may not reflect the “real world” single present dollar amount. Depending
value of a specific company if it were formally offered for sale. on the valuation method used, “Income”
might be represented by after-tax profit,
pre-tax profit, EBIT (earnings before
interest and taxes), EBITDA (EBIT plus
Gary Parker Introduction depreciation and amortization), or other
Corporate Finance Associates “What do you think my company is cash flow measures. The two most
worth?” is the question we are most commonly used methods under this
commonly asked by our clients and approach are the Single Period
prospects who are considering the sale of Capitalization Method and the Multiple
their companies. Answering this question Period Capitalization Method.
is an important step in determining whether
the timing might be right to sell a particular Single Period Capitalization Method –
company. Although there are many other This method involves converting
factors that will affect whether a business representative income for a single
owner should pursue a transaction, this period into present dollar value through
article provides an overview of the most the use of a capitalization rate
common approaches and methods used in (expressed as a percentage). The
business valuation. capitalization rate factors in the risk of
achieving the future income as well as
The leading business valuation a projected growth rate for the specific
associations, the American Society of company being valued. The key
Appraisers (ASA), the Institute of Business assumptions required in order to use
Appraisers (IBA), and the National this method include stable earnings, a
Association of Certified Valuation Analysts constant growth rate, and the prospect
(NACVA), all agree on three major for continued growth for a long time
approaches to business valuation: the period.
Income Approach, the Market
Approach, and the Cost Approach. Multiple Period Discounting Method
Under each of these approaches there are (aka Discounted Cash Flow Method) –
several methods that might be employed This method uses financial projections
depending on the specific nature of the to determine future income for several
company being valued. A brief description periods into the future including a
of the standard approaches and most terminal value and a discount rate to
commonly used methods under each convert those future values back to a
approach follows below. We conclude with present value. The advantage of this
the True Value Approach. method is that it can be used for
companies with unstable earnings and
nonconstant growth rates. It is
important that the discount rate
Valuation: Getting the Right Price When Selling Your Business 2
being used is appropriate for the
“income” being discounted as small Guideline Public Company Method –
changes in the discount rate can have This method involves using market
considerable impact on the present multiples derived from market prices
value. of stocks for companies that are
engaged in the same or similar
Market Approach industries as the subject company.
The Market Approach involves valuation This can be a helpful tool in valuing
methods that use transactional data to help private companies, but these public
determine a company’s value. These company multiples usually need to be
methods might involve private company discounted significantly to reflect the
transactions, public company transactions, higher risks (e.g., customer
as well as public company valuation concentration, management depth,
measures using current stock market data. access to financing, etc.) inherent in
The theory behind this approach is that most smaller private companies as well
valuation measures of similar companies as the “lack of marketability” of
that have been sold in arms-length private company stock.
transactions should represent a good proxy
for the specific company being valued. Cost Approach
Depending on the source of data available The Cost Approach, also known as the
and the underlying company being valued, Asset-based Approach, involves methods of
a variety of valuation measures might be determining a company’s value by
used including Enterprise Value (EV) to analyzing the market value of a company’s
Sales, EV to EBITDA, EV to EBIT, Price assets. This valuation approach often
to Earnings, etc. serves as a valuation floor since most
companies have greater value as a going
Merger and Acquisition Method (aka concern than they would if liquidated, i.e.,
Comparable Sales) – This method the present value of future cash flows
involves reviewing transactions for generated by the assets usually far exceed
companies that are in the same or the liquidation value of those assets. This
similar line of business as the company difference between the asset value and
being valued and then applying the going concern value is commonly referred
relevant pricing multiples to the subject to as “goodwill”. An exception to this
company to determine its value. might be a low-margin business in a
Proprietary data bases of private competitive industry that owns its real
company sales are often utilized in this estate, which has appreciated over time due
method. In addition, some public to its development value. In this case, the
company transaction data is available. asset value may exceed the going concern
Adjustments are commonly made to value of the business.
these valuation measures before
applying to the subject company to Adjusted Book Value Method – This
ensure an “apples-to-apples” method involves reviewing each asset
comparison. One or many comparable on the company’s balance sheet and
sales might be considered under this adjusting it to reflect its estimated
method depending on the data market value. Depending on the mix
available and the degree of similarity of assets owned by the company, other
to the company being valued. types of appraisers (e.g., real estate,
Valuation: Getting the Right Price When Selling Your Business 3
machinery and equipment) might need “Real World” or True Value
to be consulted as part of the valuation True value of a company is that which a
process. In addition, it is important to real, live buyer would be willing to pay if it
consider intangible items that might were formally offered for sale. Depending
not necessarily be reflected on the on the unique aspects of each individual
balance sheet, but which might have company, the true value may vary
considerable value to a buyer, such as significantly from a valuation determined
trade names, patents, customer lists, by any of the methods discussed above.
etc.
Consulting a professional investment
banker can best help you assess the true
Conclusion value of your company. These
The valuation methods discussed above professionals will assess your company’s
represent some of the most commonly used strengths and weaknesses and employ some
by business valuation professionals to of the commonly used valuations methods
generate an opinion of value. Although used by business valuators. They will also
considerable time and effort is involved in leverage their insight into the current
preparing formal business valuations, marketplace to help determine financing
unfortunately the results may or may not availability and assess many other factors
reflect the “real world” value of a specific to determine your company’s potential
company if it were formally offered for value in the market place.
sale.
Gary Parker is a Principal in the Corporate Finance Associates
Charlotte office of Corporate Finance 24461 Ridge Route Drive, Suite A200
Associates and holds the Chartered Laguna Hills, CA 92653
Financial Analyst (CFA) designation.
Before joining Corporate Finance T/ 949.305.6710
Associates he worked for a well-known E/
[email protected] Southeast business valuation firm as a
Certified Business Appraiser (CBA).
01/28/07
