How to Value a Business
Simply stated, the asset approach values the assets of the business. The value of the assets of a business are, however, not always easy to ascertain. For example, the value of the assets as stated on the balance sheet — "book value" — is almost always not the true value of the assets in the marketplace. If a business is being liquidated and the assets must be sold by next Friday, then book value is not of importance. However, if the assets can be sold over a course of several months, then the value of these assets is closer to their fair market value (FMV). Most of the time, assets are valued at FMV, defined as the price that a reasonable buyer would pay a reasonable seller when neither were under pressure to buy or sell. Unless you are buying a business that is very asset intensive, marginally profitable, or losing money, the asset approach usually is not the best indicator of the true value of the business.
The income approach uses one or more methods to determine the value based upon the anticipated benefits of business ownership. Simply stated, the income approach determines the value of the anticipated stream of business income. Although entire books have been written on this subject, the most relevant discussion revolves around what are the earnings and what is the discount rate or capitalization rate applied to the earnings? Earnings, as discussed elsewhere, are the adjusted profits of the business.
Most professional valuations use one of two types of earnings:
1) SDE, or seller's discretionary earnings, is a direct measurement of the true bottom-line benefit of owning a small business. SDE includes the owner's salary or take-home compensation.
2) EBITDA, or earnings before interest, taxes, depreciation and amortization, differs from SDE in one key area: it includes compensation for management. Discount or capitalization rate can vary greatly by the type of prospective purchaser and the overall risk of the continuity of the income stream. Depending on the buyer and the business, some potential areas of risk can be the size of the company, competitive forces, barriers to entry, growth rates, lack of management, etc. As a broad-brush example of risk, an investor investing in a portfolio of stocks representing the entire stock market may believe that an 8% rate of return is adequate given the enormous diversification in industry and given that these publicly held companies have top quality management. On the other hand, a potential buyer of a beauty salon may seek a 50% rate of return given the large number of competitors, high employee turnover, low barrier to entry, and the necessity of constant supervision.
The market approach determines the value of a business by comparing it to similar businesses that have been sold. Although not as complete or comprehensive as residential comparable sales, there are several very good databases of sold businesses. Businesses are seldom exactly the same, but grouping like businesses by type and or region makes comparisons relevant. VR subscribes to these databases and often checks numerous sources to find like businesses. Ratios considered when using the market approach are the price to earnings and price to revenue.