The three main methods of valuing a business used by business valuation pros include the (1) income approach, (2) market approach, and (3) asset based/cost approach.

This is the most common method for valuing a business. Under the income approach, value is determined by essentially multiplying the income generated by the business with either a "capitalization rate" or a "discount rate." The capitalization rate is the preferred rate to use because it looks at what the business made in the past to value the company for earnings in the future. In other words, the capitalization rate looks at past, or historical, earnings of the business to determine its value. In contract, the discount rate looks at the present value of future earnings. So, the discount rate attempts to predict what future earnings will be. Because it is difficult to determine future earnings with the discount rate, the capitalization rate is usually chosen.

The market approach looks at comparable information from similar companies to determine value. This is generally the preferred way to value real estate because appraisers can typically find similar homes. However, when valuing a business, valuators use this approach much less because it is different to find "similar businesses."

For example, assume a real estate appraiser is trying to value a brick colonial with 4 bedrooms, 2 baths, a 2 car garage, a new roof, a gas heater, gas hot water tank, all on an acre of land. With this information the real estate appraiser could likely find some similar properties to determine the value of the subject house. Conversely, a business valuator would not likely be able to find a business that is similar to other businesses like an appraiser could do with a house. This is because there are generally more variables to deal with in evaluating a business. As such, valuators generally do not use this approach for small businesses, but may use it for public corporations.

With the asset-based approach the business valuator looks at the assets minus the liabilities to come up with a value. This approach determines what the hard assets of the business are worth. However, this approach has some major drawbacks, one of which is the failure to value the goodwill of the business. The goodwill of a business generally refers to the intangible value of the business, i.e. the value above and beyond the assets of the company.

For example, the Coco-Cola Company may be worth 5 billions dollars under the asset-based approach. But what about the Coke trademark and product loyalty of all the consumers in the world that know about Coke. This intangible asset is a part of the goodwill of Coke and should also be taken into consideration when valuing the business (because Coke’s goodwill is worth a great deal of money).

Overall, that’s why the preferred business valuation method tends to be the income approach.

Finally, we’ll conclude this article with some additional thoughts to keep in mind.