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Business Valuations (How to Value a Business)

Introduction

Valuing a business is both an art and a science because there are no hard and fast rules. In fact, there is often a great deal of confusion among individuals about valuing businesses because of the many different methods that may be used.

With that said, while there are no set "rules" to valuing a business, there are generally accepted valuation methods and principals that most business valuators use to determine value. And once you understand some of the basic valuation techniques, you’ll likely begin to realize that business valuation doesn’t have to be as confusing as you once thought.

In this article, we’re going to explore reasons to value a business, some common business valuation misconceptions, the concept of "value" in business valuation, and the main valuation methods used by the pros.

Next, we’ll take a brief overview of business valuation to set the groundwork for understanding this topic.

Business Valuation Overview

There are generally four (4) main factors in determining value, which include:

Reason(s) for Value

Purchase or sale of business
Buy-sell agreement
Divorce
Dissolution
Etc.

Definition of value

Fair market value
Fair value
Book value
Etc.

Methods of Value

Income approach
Market approach
Asset-based approach

Type of ownership

Is the company owned by one person or a corporation with thousands of shareholders? This will impact the valuation of the company.

We’ll explore the first 3 factors in more detail on the following pages. The fourth factor, "type of ownership", deals with who the owners are, how many owners there are, and whether the business is an individual or business entity (like a corporation or LLC). (Please explore the Legal Category "Business Law" for further details on types of business entities).

Also, keep in mind this key concept -- the date the business is valued is called the valuation date. Under this concept, the value is stuck in time at the date of the valuation. That’s why businesses must be occasionally re-valued to keep an up-to-date valuation of the business.

Next, we’ll go over many of the reasons why to value a business.

Reasons to Value a Business

There are many reasons to value a business including, but not limited to:

Purchase or sale of a business
Mergers & Acquisitions
Dissolutions – i.e. termination of the business
Divorce – if one spouse owns part of a business and wants to sell the business (or his or her share of the business)
Buy-Sell Agreements – often used to determine what the business may be worth in the future
To obtain financing – if a person or entity wants to obtain financing from a bank and use his or her business as a way to secure a new loan
Litigation – if a person or entity is involved in a lawsuit, the value of the business may come into play
Tax reasons – the IRS may require a business to be valued in order to determine what gift and/or estate taxes must be paid

As you can see, businesses should be valued for more than just the purchase and sale of the business. The reason you’re valuing a business can dramatically change what value you’ll come up with for the business.

For example, the value of a business in a merger or acquisition will likely be higher than if you’re valuing the business for its dissolution, i.e. termination. Why? Because in a merger or acquisition there is another company taking over the business. In other words, another business actually wants that business. In the dissolution of a business, no one is actually buying "the business." Instead, generally just the assets, i.e. things owned by the business, are being sold (and often at a highly discounted rate). So, the value of a business at its dissolution tends to be much lower than in a merger or acquisition (or other reasons).

So, keep in mind that the reason for the business valuation can completely change the outcome of the business valuation.

Next, we’ll take a look at some common misconceptions related to business valuation.

Business Valuation Misconceptions

There are many misconceptions about business valuations. Let’s take a look at some of the most common misconceptions.

Misconception 1: Only Value a Business When You Are Going to Buy or Sell It

As mentioned on the previous page, there are many reasons to value a business. As such, you should not only consider valuing a business when it’s time to sell or purchase a business. If you only value a business during the purchase or sale of it, you’ll likely run into problems when you need a value on the business for other reasons (as mentioned on the previous page). So, make sure to fully understand the nature of your business and when its valuation may come into play.

Misconception 2: If Your Business Loses Money, It’s Not Worth the Time & Money To Value It

A business that appears to be losing money may actually be doing well. For example, many small businesses often give out large bonuses and/or other rewards at the end of the year. By doing so, it may appear that the business is not worth much. This is because the bonuses and/or rewards are listed as company expenses, and take away from the company’s profits. However, the owners and/or employees are still receiving the money, but just in a different form than profits.

Now, bonuses and rewards may be given out to owners and/or employees, but only for legitimate business reasons. If the owners give out large bonuses and/or rewards to avoid paying taxes, this is illegal and the IRS will likely be knocking on your company’s door! Giving out large bonuses to avoid paying taxes is known as zeroing out or bottoming out. Make sure to never "zero out" your business, and only grant reasonable bonuses for legitimate business purposes.

So, it’s often still a good idea to value a business even if the business appears to be losing money.

Misconception 3: I Don’t Need to Value My Business Because I Know What Some Similar Businesses Are Worth

Valuing a business is a very fact specific endeavor. Even if you know the values of some of your competitors’ businesses, that is no substitute for the value of your business. There are so many variables in a business valuation that you should not just assume the value of your business based on other businesses. It is always better to value your business based on all of your business’s factors.

Misconception 4: I Valued My Business Once, So I Won’t Have To Do It Again

Maybe not, maybe yes. Valuing a business is the same in concept as valuing other things. Values rise and fall, and sometimes dramatically in a short period of time. Just because you valued your business a few years ago does not mean that the current value is the same. In fact, it’s much more likely that the value has changed. Think about how much the value of a stock changes on the New York Stock Exchange. You’re business likely changes in many of the same ways.

Also, a key concept (which we’ll discuss later) to remember is that a business valuation only applies to the particular date in which its valuation is completed.

Next, we’ll take a look at what is "value" in business valuation.

What is "Value" in the Business Valuation?

The whole reason behind business valuation is to "value" a business. But what exactly is "value" in the business valuation? This is often where much of the confusion comes from in business valuations. Let’s go over this step by step.

First, valuing a business is an opinion. Stated differently, value is an appraisal of worth. So, the words "value" and "appraisal" are generally synonyms. But how do you know what something is worth? Well, it depends on how you define the word "value."

Second, there are multiple ways to define "value", some of which include the following:

Fair market value (discussed below)
Fair value (discussed below)
Book value – the assets of the company
Investment value – what something is worth to a specific buyer or owner
Intrinsic value – determined by outside consultants without actually looking at the specific business (has little value in business valuations)
Going concern value – what a business will be worth in the future
Liquidation value – what a business is worth when it is going out of business

The definition of value will often depend on the reason why you’re valuing the business. For example, if the business is being dissolved, you’d choose the liquidation value. If you’re looking to invest in the business and want to know what it is worth, you’d choose the investment value.

With that said, the most common types of value are the first two mentioned above: fair market value and fair value.

On the next page, we’ll look at both fair market value and fair value.

Fair Market Value and Fair Value

Fair Market Value

"Fair market value" can be defined as the amount at which property would exchange hands through an arms length transaction between a willing buyer and seller, when both parties have reasonable knowledge of all of the relevant facts. In other words, an "arms length transaction" means that the price is not affected by the relationship between the parties. For example, if dad sells his car to his son, this would not be considered an arms length transaction (because dad is much more likely to give his son a "deal"). However, if dad sells his car to a bidder at an auction this would be an arms length transaction.

Fair market value also attempts to value property at its highest and best use. For example, a plot of land might be valued at $100,000 in a residential neighborhood. But, if the zoning is changed to allow that plot of land to also allow commercial use, then the fair market value might jump up tremendously, perhaps to $500,000. Fair market value is commonly used by court systems, the IRS, and many business valuation experts.

Fair Value

According to the Revised Model Business Corporation Act (RMBCA), "fair value" is defined as "the value of shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any depreciation or appreciation in anticipation of the corporate action, unless an exclusion would be inequitable." Huh? That’s sure a mouth full (and also a reason why there’s confusion about "value"). Let’s break this definition down so that it is easier to understand.

Stated in another way, fair value attempts to value shares of a company immediately before the company takes some action that dissenting shareholders object to (i.e. that owners in the company object to). Fair value generally applies to dissenting shareholders, or individuals who object to a particular action taken by a corporation where they own shares in the company. Many factors can go into computing fair value, including:

The market price of similar companies
Goodwill of the business

the value of the business above its hard assets
this is a very important area in business valuations (and we’ll discuss this in more detail later in this article)

Book value of the business

The "hard" value of the business
Assets – liabilities = book value

Nature of the business

what the business does

Economic industry outlook in which the business operates
Financial condition of the business

how much debt and assets that the business has

Ok, so once you know the reason for the business valuation (as previously discussed), you’ll then select the appropriate type of value (such as fair market value or fair value). Then, you’ll go to the third overall step – the method of valuation.

Next, let’s take a look at the 3 main methods used to value a business.

Business Valuation Methods

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.

The Income Method 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 Method Approach

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.

The Asset-Based Method Approach

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.

Conclusion

In this article, we talked about reasons to value a business, some common business valuation misconceptions, the concept of "value" in business valuation, and the main valuation methods used by the pros. You should now have a better idea about how businesses are valuated.

If you’re thinking about valuing your business, you’ll want to find a business valuation expert. CPAs (certified public accountants), lawyers, or other professionals generally can conduct a business valuation of your company. As with all services, shop around and compare the different prices and services out there. The cost to hire a business valuation expert can vary dramatically depending on the expert’s fees, and all the variables needed to take into consideration for your business.

Once you do find and hire a business valuation expert, you should receive a business valuation report upon the completion of the valuation. The report should thoroughly discuss how the value of the business was determined, along with the value and method used in determining the final value of the business. Business valuators may discuss several different types of methods in the business valuation report, but only 1 method should actually be used in determining the final value of the business. The business valuation report should not average or weigh different methods together for a final value.