3 Small Business Valuation Approaches

Although you may understand that increasing the intrinsic value of your business is necessary if you want to attract investors or buyers, knowing how you increase that value can be much more complex. To get a handle on this, you must understand how business valuation works from an appraiser’s perspective. So, let’s look at the three most common business valuation approaches appraisers use.

Price or Value: Which is More Important??

When business owners seek investors or buyers, they’re often concerned with the price others will pay for their business or an equity stake in their business. However, while buyers and investors care about the cost they will pay for a business, they’re more concerned with the value they’ll receive for their investment.

Those looking at your business from the outside will ask a lot of questions. For example, they might ask, “Is this business viable? Does it offer quality goods and services? Does the business have transferable patents, copyrights, or trademarks? Is the business centered around one customer, or does it have multiple customers? What about the team members and managers? Are they older or younger? Will they be around a long time? Do you overpay them or underpay them? Do you have up-to-date operational systems in place, and do you utilize them appropriately?”

You see, each of those questions are centered around value. So, which is more important to buyers and investors — the value of your business, or the price of your business? According to Warren Buffett, “Price is what you pay. Value is what you get.” Therefore, if you’re looking at your business from a buyer’s perspective, you’ll want to build a business so valuable that buyers are willing to pay a higher price than the “market” says your business is worth.

Three Business Valuation Approaches

If you strip business valuations down to their most basic level, you’ll see that appraisers most often use one of three approaches to determine your business’s value. Among these three approaches, one is king. However, you must understand each approach to truly understand how to grow value in your business.

1. The Market Approach

Appraisers may use a market approach to determine the value of your business. But the key to this approach lies in whether your company is a publicly-traded one or a privately held one.

The Guideline Public Company Method

If your company is large and publicly traded, then appraisers will determine the value of your shares by looking at the price per share of comparable companies on the Dow, the S&P 500, or the Russell 2000. This is known as the Guideline Public Company Method. This approach works well for large, publicly traded companies. However, it’s difficult to compare a company that size to a private mid-size company or to a small private company. Therefore, this method won’t apply to most business owners.

The Guideline M&A Transaction Method

It’s more likely that appraisers will use the Guideline M&A Transaction Method to determine the value of your small or midsize business. In this method, evaluators look at the sales of similar companies within your industry. They can use your business’s classification within the North American Industry Classification System (the NAICS) or within the Standard Industrial Classification code (the SIC) to further narrow down comparable businesses in your industry. Then, business appraisers will assess how similar the businesses that have sold within your industry are to yours. They’ll examine things like location, clientele, and revenues when comparing your business with like companies.

Unfortunately, most private companies’ information is, well… private. Therefore, appraisers will often have a difficult time comparing your company to other private companies because they won’t have access to the other business’s revenue streams, profit margins, or demographics. This lack of public information can make determining your business’s worth using the Market Approach Method a difficult endeavor.

2. The Asset Approach

Because the Market Approach Method can be so difficult, many appraisers may choose to avoid such difficulties altogether. They could choose to do so by using an asset approach to determine the value of a company. With this approach, they’ll review your company’s financial records, running basic calculations to determine the value of your tangible or intangible assets.

The Adjusted Net Asset Value

First, appraisers could calculate your company’s adjusted net asset value. While this technique sounds intimidating, it’s fairly straightforward. An appraiser simply looks at the replacement value of your assets and liabilities in the event of a disaster or a sale. This could be the calculated value of your assets if you lost everything in a fire, or the amount of money you’d get for your assets if you were to sell them.

To determine this “replacement” or “liquidation” value, appraisers will examine your company’s balance sheet. First, they see how much your assets are worth on paper. They follow up by subtracting any liabilities owed on your assets. Because this method uses the company’s book valuation of your assets, it’s often used as the baseline, or floor of your company. Therefore, if you’ve depreciated your assets on paper, be wary of having an appraiser use this method to determine your business’s value if you want to sell it for profit.

Excess Earnings Method

Another asset approach appraisers might use is called the excess earnings method. It’s more complicated than the adjusted net asset value method. Basically, an evaluator determines the value of intangibles. The appraiser will calculate the excess return on your company’s assets to get an intangible value. Since this calculation method assesses things like revenue from a blog or royalty income from published works, it’s very seldom used to determine a company’s worth in the event of a sale.

3. The Income Approach

Finally, there’s the Income Approach. If appraisers don’t use the market approach or the asset approach to determine a company’s value, this is what they typically use. When it becomes necessary to have your business appraised for sale or investment purposes, an evaluator will usually look at your income or cash flow and compare it to the risks your business faces. In fact, the income approach is so valuable that Shannon P. Pratt, chairman of Shannon Pratt Valuations, said, “The income approach is king. Hands down. The income approach is key. Whatever approaches to value are used, they should be reconciled with the income approach.”

Capitalized Historical Cash Flow Method

Within the income approach, you’ll find the capitalized historical cash flow method. Just like it sounds, this appraisal approach looks at your historical cash flow. The appraiser takes the weighted average of that cash flow and divides it by a cap rate, or a capitalization rate, that reflects the risk factors within your business and its expected growth in the future.

The downside to using this cash flow method is that appraisers must use their own judgment to come up with that capitalization rate. They determine the types of specific risks companies have and how much those risk factors affect the companies. Therefore, the cap rate can vary from appraiser to appraiser which means your value can vary from appraiser to appraiser.

Discounted Future Cash Flow Method

Appraisers who use this method value projected future cash flows of your company then discount the future cash flow with a discount rate, reflecting the riskiness of the futuristic cash flow. I’m oversimplifying this process. But essentially, they’re discounting your business’s value by the riskiness of the future cash flow.

The tricky part of the discounted future cash flow method is that appraisers must make a subjective decision about when your company’s cash flow will cease, reduce, grow, etc. Your business will not last forever. Therefore, appraisers must make an educated guess as to when your company’s cash flow will cease or terminate.

Why Business Valuation Matters

You don’t need to learn how to value your company. But you need to understand the various approaches to business valuation. Cash is king, or, in the world of valuation, the income approach is king. Within the income approach, appraisers either look backward to see what your company’s done, or they look forward to seeing what your company has the potential to do. Profits alone don’t determine your company’s historical growth, nor do they determine your future potential. No, your company’s qualitative factors increase or decrease its quantitative numbers that appraisers use to value your business. Your qualitative and quantitative factors together increase the value of your company.

However, knowing that the qualitative works with the quantitative to grow the value is only a piece of the puzzle. As you work to improve each of the qualitative areas of your business, other areas will respond to that movement, creating the need for adjustment. This is a process that is often long and difficult but could lead to great rewards within your business. If you’re interested in learning more about how you can impact your business’s valuation, I’ve written all about the process in my latest book, Your Baby’s Ugly. Stop putting all of your efforts into the quantitative side of your business (which will dry up when you exit) and begin working on the qualitative areas that can drive value and profitability.