Have you ever asked what business valuation methodology should I use to determine my value?
When determining the most probable selling price of a business, there are three main approaches to value: The Market Approach, the Income Approach, and the Asset Approach.
If you are thinking of your exit strategy, most likely you have asked, what is my business worth. The underlying principle of the Market Approach (“Comps”) is the principle of substitution. It states that “a buyer will pay no more than that which he/she would have to pay to purchase an equally desirable substitute.” The Market Approach is used in the valuation of residential real estate under the names Market Comparison, Market Analysis, and The Sales Comparison Approach. In selling a business, when you ask the question how much is my business worth, like in asking the question how much is my home worth, this method compares the subject business to similar businesses that have sold.
The underlying principle of the Income Approach (“Cash flow”) is the principle of future benefits (expected economic benefit) and the level of risk associated with the investment. This is the most common approach used by business appraisers and will be considered in the valuation process. It says that “economic value reflects anticipated future benefits” and uses methods that convert expected future financial benefits into a present value. It projects out an economic benefit (cash flow) and discounts it back to the present time using a discount rate. The discount rate is specific to the business that is being valued (risk of the investment). The buyer must be willing to pay a price that is at least as high as that which the seller demands to give up their future opportunity.
The underlying principle of the Asset Approach (“Asset value”) is the same as the Market Approach since both buyers and sellers look at the value of a business as the sum of the value of the parts, which is the “substitute”. However, the asset approach uses methods based on the value of the underlying assets of the business. Some companies run with little to no cash flow and the asset approach is typically considered. When the business would be more valuable if its assets were liquidated instead of continuing to run for cash flow, the asset approach can prove most valuable.
There are times when all three approaches will be used.
Additionally, there are three methods that fall under the Market Approach to value: Direct Market Data Method (DMDM), Guideline Public Company Method, and the Merger & Acquisitions Method.
The DMDM method of the market approach is a very common method used by business brokers to value businesses whose values are typically around $1Mil. and under.
Here are the steps to perform the DMDM valuation method:
1. Determine the Discretionary Earnings (DE) of a business. The definition of DE is earnings before taxes, interest income (or expense), non-operating and non-recurring expenses, depreciation and other non-cash charges and prior to deducting an owner’s/officer’s compensation. Then recast the financial statements (balance sheet, income statement, tax returns), and normalize the income and expenses and cut unusual and unnecessary events. This will create a correct picture of the earning ability of the business and the assets being transferred.
2. Determine the parameters for the subject, such as sales, DE, current assets included in the sale, the fair market value of the assets and liabilities to be retained by the seller and the primary SIC and/or NAICS codes. Ask how much risk is involved in the business? Is the subject business of equal risk to other businesses?
3. Database research to collect data on the business type to draw statistical conclusions. This is where valuation becomes more of an art, and since knowledge is power, the more information we have, the less risk there is in the process. The lower the coefficient of variation (CV), the better. The higher the R-squared the better, and using the median rather than the mean is also better. Using the harmonic mean will give you better value statistically, but may not represent the market. The trick is to drop the unrepresentative data points without “cherry picking” any data.
4. Evaluate sales price vs. DE and Sales Price vs. Revenue. Some buyers buy the revenue of business because they want the customer base and they feel that they can scale the business up.
5. Select the proper multiples (SP/REV, SP/DE, EBITDA) ratios, Mean vs. Median, CV, and R-squared of linear regression, and calculate the values (Revenue x SP/Revenue Ratio and DE X SP/DE ratio).
6. Adjust the values considering the inventory, the FMV of the assets and liabilities retained, cash and securities, A/R, prepaid’s etc. Also, account for non-operating assets and surplus equipment, and the free and clear or assumed obligations.
7. Once the values are adjusted, it is time to reconcile the values and choose consistent data, overdispersed data and consider the big picture. You should ask, what is the “quality” of the intangible assets of the business and how does this affect the subject businesses value? Look at it as CAP rates for businesses, if you will. It includes a built-in assumption about growth.
8. Report the conclusion.
There is much more than meets the eye when it comes to deciding a proper business valuation. If you are interested in selling your business and would like to hire a Business Brokerage team with a proven record of accomplishment, call Wayne Wright directly at 720-436-1472.