How do you Calculate the Value of a Business?

Oct
Business Valuation October 28, 2020

Authored by Josh Gifford, CPA, CFE

What is the value of a business and how is it calculated? How much would someone pay for it? The question sounds simple, but it’s part of the fundamental definition of fair market value according to the American Institute of Certified Public Accountants (“AICPA”). The full AICPA definition of fair market value is as follows:

“The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”[1]

There is a lot to consider in determining the price hypothetical parties would agree on and the question “how much would someone pay for it?” quickly becomes, “how much should someone pay for it?”  Taking this approach, an appraiser considers widely accepted valuation theories and principles and applies them to the specific business or business interest at a certain point in time. The appraiser generally also considers the industry, economy and several other factors. Needless to say, the valuation process can get very complex.

There are three approaches business valuation professionals use to calculate the value of a business.

Common Business Valuation Approaches

  1. Income Approach
  2. Asset Approach
  3. Market Approach

Theoretically, with ideal information, all three approaches would be expected to yield the same value. However, depending on what information is actually available, a valuation analyst will choose one, or a combination of all three approaches in his or her analysis and the indicated values can vary.

Income Approach

Under this approach, what gives a business value is the ability of its assets to provide a return on investment. The return on investment is the future earnings expected to be generated by the business. The income approach is focused on future earnings potential.

Within the income approach, there are various methods. The two most common methods are:

  • Capitalization of earnings
  • Discounted cash flow

A valuation analyst will generally use the capitalization of earnings method when historical revenue and expenses of the business are stable. In this case, the analyst utilizes historical profits, removes any anomalies, and concludes on an annual cash flow reasonably expected to be generated by the business prospectively. Then, using a perpetuity calculation the annual cash flow is capitalized, which essentially projects the cash flow into perpetuity (at a reasonable and sustainable growth rate). The perpetuity calculation expresses the future cash flow in terms of value at the calculation date. As one might expect, determining the right capitalization rate is complex. In fact, there have been large-scale studies on this topic, and it has become an entire discipline in itself.

The discounted cash flow method will generally be used when the historical revenue and expenses of the business are volatile, or the business is consistently growing at an unsustainable rate or even contracting. In this case, using input from management, the analyst will project annual future revenue and expenses until business operations are expected to stabilize. At the estimated point in the future when profits are expected to be stable, the annual cash flow will be capitalized, and all annual cash flows will be discounted back to present value. This method is similar to the capitalization of earnings method with the additional flexibility of projecting cash flows at varying rates for a discrete number of years.

The income approach is common because it values a business based on the cash flow that all assets, whether tangible or intangible produce when working as a mass assemblage.

Asset Approach

The asset approach is what most people will think of when trying to determine the value of a business. In the asset approach, a valuation analyst will generally start with the company balance sheet, where the company’s assets and liabilities are shown. The liabilities are subtracted from the assets to calculate net “book value” of equity. The problem with net book value is that many assets are listed on the balance sheet at the cost originally paid for them, not what they could be sold for today. Also, the balance sheet may not list intangible assets such as brand recognition, patents, copyrights, contracts, customer lists, goodwill or other proprietary information. These intangible assets all have real value and are likely not on the balance sheet.

In addition, the cost of appraising discrete assets, including intangible assets, can be cost prohibitive.  Consequently, the asset approach is typically reserved for use in unique circumstances for businesses with ongoing operations. Or alternatively, the asset approach would be a great way to value a business that has gone bankrupt and is selling off everything it owns.

The asset approach is a good way to value a company’s assets, but may be time consuming and cost prohibitive to value how they work together to produce earnings. 

Market Approach

The market approach is another more intuitive method of determining value. This approach focuses on the question, “has anyone else bought something like this before, and what did they pay for it?” Two common methods within the market approach are:

  • Guideline public company
  • Guideline transaction

Public companies are actively traded on the open market; therefore, their value is known and readily ascertainable in the form of stock price. For example, the value of a publicly traded company can be thought of as the price of one share of stock multiplied by the total number of shares outstanding. Let’s say the business which is the subject of the valuation is sufficiently similar to a pool of public companies. An analyst will derive “multiples” from the public companies based on certain metrics, such as earnings, for example, a stock price-to-revenue multiple. The analyst will then apply the multiple to the subject business to determine a value indication. Applying multiples essentially means preserving the ratio between total value and a specific measure, such as total revenue.

If there is not a pool of public companies sufficiently similar to compare, the guideline transaction method may be another option. Valuation analysts search databases to find records of businesses being bought and sold. If the analyst can successfully identify a pool of transactions for businesses deemed sufficiently similar, then the valuation analyst will derive multiples from the transactions and apply them to the subject business.

The market approach focuses on observable data of other businesses, and therefore is used as a proxy measure in the determination of value. 

Which is the best method to value a business? 

Usually, consideration of all methods is best, and frequently a combination of one or more methods is used. For example, a valuation analyst may start with the income approach to determine a value indication. Then the analyst may check for guideline public companies and guideline transactions to determine whether those methods can appropriately be applied. Perhaps he or she also determines that the business owns a piece of real estate that is not involved in the operation of the business. Since it is not an operating asset, it should be valued separately, perhaps using the asset approach, and added to the value determined using other methods. As every business is unique, a uniquely tailored consideration of all three approaches is the best way to ensure the business is valued as accurately as possible.

Most importantly in addressing the value of a business is that a trained and independent business valuation professional is used. Valuation professionals generally hold specific designations indicating that valuation is their area of focus, including Certified Public Accountants (CPA) who are further trained and Accredited in Business Valuation (ABV) by the American Institute of Certified Public Accountants, or Accredited Senior Appraisers (ASA), under the auspices of the American Society of Appraisers.

[1] AICPA International Glossary of Business Valuation Terms.

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