As a business owner or shareholder, at some point you may have thought about what the value of your business is, perhaps while thinking of raising funds, evaluating the return on your investment or simply considering the future of your business. And thinking about value, you may have question what the right way would be to value your business. Perhaps using a market benchmark? Or cash flows? Or perhaps a rule of thumb specific to your industry? Ultimately, is there a right way to value your business, or is there one that is preferred over another?

In our previous article, we mentioned that business valuations are a hybrid of art and science. At its core, business valuations are about determining the ‘economic worth’ of your business. This involves assessing various elements, including financial performance, market dynamics, operational efficiency, and future growth prospects. Given this complexity, various business valuation methods exist, each designed to help you accurately gauge your company’s worth under different circumstances.

Now that is a lot of words, but what does that mean? In simple terms there are a variety of factors to consider when choosing the right approach to value a business, and so lets first start by taking a look at some of the most popular approaches and where these may typically be applied:

Business Valuation Methods

When considering how to value your business, there are 3 broad categories that valuation approaches fall under – 1) the asset / cost approach, 2) the income approach and 3) the market approach.

1. Asset / Cost Based Method

Driven by a business’ balance sheet, this method evaluates the value of a business by assessing its net assets. This approach can be executed in two ways:

• Going Concern Asset-Based Method: This method calculates the net value of business assets as listed on the balance sheet, subtracting liabilities to arrive at the net worth.
• Liquidation Asset-Based Method: Here, the focus is on determining the net cash a business would generate if all its assets were sold and liabilities cleared.

This method is particularly suitable for businesses with clear distinctions between the company’s assets and its owners and where assets make up a significant portion of business value. For instance, manufacturing corporations, which operate as separate legal entities, can utilize this method effectively. Conversely, sole proprietorships might find this method less applicable, as assets may be personally owned and may be used interchangeably for business or personal purposes.

2. Earnings Value / Income Method

Driven by cash flows, this approach focuses on a business’s ability to generate future income. It utilizes historical performance and financial data to forecast potential earnings.

• Capitalized Cash Flow (CCF): This method estimates value based on historical earnings, projecting future revenue generation based on past performance.
• Discounted Cash Flow (DCF): This method predicts future cash flows and adjusts them to present value, offering a current worth based on anticipated performance based on recent business efforts.

The earnings value method is ideal for established businesses with a consistent history of growing revenue and a push for profitability. It requires a solid foundation of data, including client relationships and revenue-generating systems, as well as an understanding of all the qualitative factors that impact the business. However, it’s essential that the assumptions underpinning these projections are based on tangible, reliable factors to withstand scrutiny.

3. Market Value Method

Perhaps the most common method and driven by industry benchmarks, this method determines business worth by comparing it with similar enterprises in the market. It relies on recent data from comparable businesses to establish a benchmark.

For example, if a peer company in your industry was recently sold within a specific price range, this method can help you estimate your business’s value based on such transactions. This approach is particularly effective in saturated industries where frequent buyouts occur, allowing for clearer comparisons, or where the path to profitability and cash is not immediately clear and market sentiment is a key driver of value.

Choosing the Right Valuation Method

Given the variety of options, what then is the right approach for valuing your business? In truth, selecting the appropriate valuation method hinges on several factors:

Purpose of Valuation: Consider why you are valuing your business. Different scenarios, such as selling, merging, or securing financing, may necessitate different approaches.

Nature of the Business: Recognize the distinct characteristics of your industry. For example, asset intensive businesses cannot be valued in the same way as a professional services business, given the stark difference in their value drivers.

Legal Requirements: Ensure the chosen method meets any legal standards applicable to your situation. Courts, tax authorities and account bodies may scrutinize the assumptions behind valuations, particularly if they seem optimistic or are generated under non-standard circumstances.

Stage of the business: An early stage business is generally much harder to value than a mature business, and the approaches used are generally significantly different due the predictability of cash flows.

The reality therefore, unfortunately, is that choosing a valuation approach is not simple. Each business is different, in that is has a unique set of value drivers and circumstances which may be tough to capture directly using just a single approach. Choosing the right approach therefore required careful evaluation of such factors and different approaches may lead to very different results.

Professional evaluators, such as CBVs here in Canada, will generally look to using some combination of these approaches to arrive at a value that is suitable, both from a qualitative and quantitative perspective, with the aim of reflecting many of these factors in the various assumptions that are involved in arriving at the fair market value of a business

What does this mean then for business owners?

Ultimately, there is no right answer to the question of what the best approach to value a business is. Within the major categories we highlighted above, there are a multitude of ways in which business valuation can be approached, and the right approach can come down to availability of data, time spent and sometimes even personal preference.

Business valuation is a critical question for every business, influencing everything from financial decisions, ownership transfers to expansion decisions. By understanding what truly drives the value of a business, stakeholders can then select a method that aligns with their business’ needs. Given the variety of options available and the complexity of each, understanding the right approach to maximizing value can be a challenge. In such cases, a professional valuator, such as a CBV, could help provide objectivity, credibility and peace of mind to business owners, while also providing insights into value drivers that may not be apparent at first glance.