Explaining business valuation approaches
Business valuations are needed determine true real value of a business. If you own a business, it is an important asset and it is vital that you know the value of your business. But how exactly does a business valuation work? Though not quite as easy as assessing the value of an asset, such as shares, where you simply multiply the amount of shares you own by the closing price of the shares, a skilled business appraiser can supply you with a sound business valuation.
Many people try to create their own business valuation simply by factoring in the historical financial statements of the company, but to correctly perform a business valuation, many other factors need to be considered.
Financial statements are created using GAAP (generally accepted accounting principles). This means that amortisation, depreciation and other expenses are recorded based on accounting rules and not on economic realities. A financial statement is also unable to apply to the statement any intangible assets a company might have, thus not reflecting an accurate business valuation.
VALUATION PROCESS
Credible and defensible business valuations can only be achieved by Accredited Business Appraisers who normally follow correctly all the necessary the steps in the process described below:
• Full information (operational, financial and nonfinancial) underpins sound valuations. Curiosity is as important as calculating ability and the appraiser must ask lots of questions.
• The value lies in the future earnings of the business, so both internal and external risks and opportunities must be considered.
•Financial accounts for most SMEs will require “normalisation”, i.e. identification of discretionary expenses and reasonable owner’s remuneration.
•All approaches should be considered and appropriate methods applied.
•A Sanity Test should be applied to all valuation conclusions and a range is generally more accurate than a precise figure.
That said, there are three fundamental ways to measure what a business is worth: The Asset Approach, the Market Approach and the Income Approach. Within these approaches there are a number of other methods that are not to be explored here.
THE ASSET APPROACH
This views the business as a set of assets and liabilities that are used as building blocks to construct the picture of business value. The asset approach is based on the so-called economic principle of substitution which addresses this question: What will it cost to create another business like this one that will produce the same economic benefits for its owners? Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets and liabilities. The difference is the business value. Sounds simple enough, but the challenge is in the detail: figuring out what assets and liabilities to include in the valuation, choosing a standard of measuring their value, and then actually determining what each asset and liability is worth.
For example, many business balance sheets may not include the most important business assets such as internally developed products and proprietary ways of doing business. If the business owner did not pay for them, they don't get recorded on the "cost-basis" balance sheet!
THE MARKET APPROACH
This approach, as the name implies, relies on signs from the real marketplace to determine what a business is worth. Here, the so-called economic principle of competition applies: What are other businesses worth that are similar to my business? No business operates in a vacuum. If what you do is really great then chances are there are others doing the same or similar things. If you are looking to buy a business, you decide what type of business you are interested in and then look around to see what the "going rate" is for businesses of this type. If you are planning to sell your business, you will check the market to see what similar businesses sell for.
It is intuitive to think that the "market" will settle to some idea of business price equilibrium - something that the buyers will be willing to pay and the sellers willing to accept. That's what is known as the fair market value: the business price that a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, and neither being under compulsion to conclude the sale.
THE INCOME APPROACH
The income approach takes a look at the core reason for running a business - making money. Here the so-called economic principle of expectation applies: if I invest time, money and effort into business ownership, what economic benefits and when will it provide me?
Notice the future expectation of economic benefit in the above sentence. Since the money is not in the bank yet, there is some measure of risk - of not receiving all or part of it when you expect it. So, in addition to figuring out what kind of money the business is likely to bring, the income valuation approach also factors in the risk. Since the business value must be established in the present, the expected income and risk must be translated to today.
CONCLUSION
In today’s turbulent business environment business appraisals are needed for a variety of reasons such as mergers, acquisitions, business planning, reorganisation, spin-offs, liquidations, bankruptcy, buy-sell agreements, shareholder disputes, insurance claims, damages litigation, initial public offerings, etc.
Business valuation is a sophisticated blend of art and science that aims to provide an impartial opinion of value. In order to achieve that, the business valuation should involve a forensic investigation of main balance sheet, profit and loss items as well as other financial and non-financial information.
