Business valuation refers to the set of procedures for determining an organization’s economic value. Although it sounds quite simple, business valuation requires the right preparation and thought for carrying out the procedures flawlessly. Having an up-to-date business valuation is important for a number of reasons. You may want to sell off your business due to health or family reasons or due to retirement. You may require equity financing or debt for cash flow issues or expansion. Before investing in your business, potential investors would see the value of your business. Business valuation is also needed for adding shareholders. Whatever be the reason, the economic worth of your business depends on several factors such as your balance sheet, current economic condition and more. There are three major approaches to business valuation and each of them includes several methods which are applied based on the nature of the organization.
Let’s have a look at the three common approaches to business valuation and how they work:
- Income Approach
Income approach considers the prime objective of a business which is ‘making money’. This approach is based on estimating the present value of future benefits. It estimates the business value by considering the future income over a time period. Income approach focuses on the future expectation of economic benefits. And because it estimates on the basis of future income, there is also some risk involved like not getting the anticipated amount of money. Thus, this approach also includes the risk factors. Since the business value needs to be established in present, the expected future income and risk are also translated to today. Two commonly used methods in this approach are Discounted Earnings Method and Capitalization of Earnings Method.
2. Asset Approach
In this approach, the business is viewed as a set of assets and liabilities which are used for constructing the picture of business value. The approach is based on the principle of substitution which states that a potential buyer will not pay more for a business than the cost in which he can acquire a substitute property with same economic benefits. Every business has assets and liabilities and the difference between these two is the business value. Although it sounds simple, estimating the details of assets and liabilities, selecting a standard of measurement and determining the worth of each asset and liability could be challenging.
3. Market Approach
This approach is based on the signs from the real market place for determining the worth of a business. The valuation expert identifies the business entities comparable to the subject business. Comparing subject business to sold businesses helps in calculating the value of an equally desirable business from the standpoint of investment or ownership. Market approach is an excellent way of determining the fair market value of a business. The commonly used methods in this approach include Guideline Public Company Method, Multiple of Discretionary Earnings Method, Guideline Company Transactions Method and Gross Revenue Multiple Method.
These approaches to business valuation are used by the professionals to generate an opinion of value. Business valuation involves considerable investment of time and effort but unfortunately the result may not match with the value of the subject business in the real world, if it were offered for sale.