How Does a Business Valuation Work?

How does business valuation work

If you are a business owner, you have likely heard of a business valuation, but unless you have had one done, you may not understand the intricacies of the valuation process and how it can be utilized. In the most general terms, a business valuation is the process of determining the value of a business or business interest. A valuation can be helpful or even essential to owners or potential investors in a wide variety of applications, including due diligence for potential investments, mergers and acquisitions, finance agreements, settling estates, estate tax, partner buyouts, owner disputes, purchase price allocations, divorce settlements and more.

Understanding what a business valuation is and how it works can help you decide what type of business valuation you may need. Find out if business valuation services are needed for your business by reading through the following information.

What Are the Various Types of Business Valuations?

A business valuation begins with determining the applicable standard of value. The most common standards of value include:

  • Fair Market Value
  • Fair Value
  • Investment Value

The conclusion of value will differ depending on the standard of value applied. For example, a fair market value valuation is based on a hypothetical buyer and a hypothetical seller, whereas an investment value valuation is based on a specific buyer and seller. A company considering an acquisition of another business may want to consider an investment value standard of value. The investment value of the target company would consider synergies to be gained between the target and the acquirer and could be helpful in evaluating the investment potential. Alternatively, a fair market value valuation of the same company would not consider any synergies or considerations specific to the actual parties involved.

A level of value should also be determined. Common levels of value include:

  • Controlling, marketable
  • Controlling, non-marketable
  • Non-controlling, marketable
  • Non-controlling, non-marketable

As with various standards of value, different levels of value will result in differing conclusions. Control generally refers to the ability to direct the management and policies of a business enterprise. An ownership interest greater than 50% will generally include controlling features and demand a higher price than a non-controlling interest. For example, a 5% ownership interest would typically not have the ability to affect company policy, hire or fire employees, etc., and would be worth less, on a percentage basis, than a 60% controlling ownership interest.

Marketability refers to how quickly an ownership interest can be converted to cash and at minimal cost. An ownership interest in publicly-traded stock would be considered marketable because it can quickly be converted to cash. Alternatively, ownership in a closely-held entity would be more difficult to convert to cash and would be considered a non-marketable interest. Studies show that marketable interests are worth more than non-marketable interests. Notwithstanding, some legal circumstances may dictate that a relevant valuation, even for a non-controlling, closely-held interest, should not include discounts for lack of control or marketability.

Knowing which type of business valuation you need will help you arrive at the right conclusion of value.

Who Performs Business Valuations?

Various groups offer business valuation services including:

  • Credentialed and specialized business appraisers
  • Business brokers
  • Industry experts

business valuation

Business valuation is both an art and a science and the quality of a valuation will depend on who is performing the valuation. The most defensible valuation will be prepared using a thorough approach requiring more than just a set of financial statements or a few hundred dollars of work. A more encompassing approach might integrate forensic accounting, discussions or interviews, statistical analyses, professional judgment, and may also require understanding of various disciplines including accounting, taxation, corporate finance, economics and perhaps statistics.

The highest-qualified professionals oriented to value closely-held companies are generally Accredited Senior Appraisers (ASA) credentialed by the American Society of Appraisers, and certified public accountants (CPA) who are additionally accredited in business valuation (ABV) by the American Institute of Certified Public Accountants (AICPA).

Common Business Valuation Methods

In general, there are three common approaches to business valuation. In theory, each approach should result in the same conclusion of value. However, depending on the type of business and what information is available, some approaches are more applicable than others. In many cases, a valuation analyst may use a combination of all three methods.

Asset Approach

asset approach

When most people think of a business valuation, they likely assume that it is something like the asset approach. This approach values a business based on the company’s balance sheet, which lists assets and liabilities. The valuation analyst adjusts assets and liabilities to the appropriate standard of value, such as fair market value, and subtracts the company’s liabilities from its assets to determine the net value.

This approach is not commonly used for companies that have ongoing operations but can be used for holding companies. Financial statements generally report assets and liabilities at historical cost and often do not include intangible assets, such as intellectual property and goodwill.

An asset approach can be rigorous and costly as it may require the independent appraisal of individual assets on the balance sheet including intangible assets. Intangible assets are often valued using an income or market approach method. Thus, the income and market approaches are more commonly used to value an operating business.

Income Approach

The income approach to business valuation is based on expected economic benefits the ownership is expected to generate. This approach is common because the value is based on the cash flow that all assets of the business produce including any intangible assets, such as reputation.

Valuation analysts typically use either a capitalization of earnings method or discounted cash flow method to calculate the present value of expected earnings. Both of these methods are complex, and they require expertise and thorough understanding of the discipline to obtain accurate valuations.

Market Approach

The market approach to business valuation considers public company data and data from purchase and sale transactions of similar businesses in the industry. The valuation analyst will make comparisons between the business being valued and other similar companies to derive indications of market value. The usefulness of a market approach is dependent on the amount and quality of data available.

When Is a Business Valuation a Good Idea?

A business valuation can be a good idea when you encounter potential investments, mergers and acquisitions, finance agreements, estate settlements, estate tax, partner buyouts, owner disputes, purchase price allocations, divorce settlements and more.

How To Prepare for a Business Valuation

Preparing for a business valuation requires gathering significant amounts of documentation. A valuation will likely require historical financial statements as well as tax returns and other documentation as requested by the valuation analyst. Also, the valuation process may involve interviews with the business owners. Being prepared to answer in-depth questions is a good place to start.

Professional Business Valuation Services

The process of business valuation can be complex and requires a thorough understanding of accepted valuation theory and principles. RMA’s business valuation services can help in a variety of circumstances, from litigation to selling, merging or acquiring a new business. Let our team perform a valuation that will yield accurate and defensible results that you can trust. Contact us today.

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