Defining Value

Before we begin discussing business valuation it is important to define what value is. When asked, most people will struggle to define it then end up using an example like a one dollar bill is worth more than a quarter. Value is difficult to define without comparing at least two items. The comparisons must be well defined to have any meaning. For example a rare quarter may be worth more than a common dollar bill. The first step in any valuation is to accurately and completely define the property that is being valued.

Value is also subjective. Someone who needs a quarter to plug a parking meter in order to avoid a parking ticket would gladly pay a dollar or more for a quarter. Similarly, one business may have a number of values. A strategic buyer that can plug the customers of the business into its existing system may perceive more value than a person who is going to run the business day-to-day. The second step in valuation is defining for whom the property is being valued.

What is a Business Valuation?

A business valuation is simply an estimate of what a business is worth based its hypothetical sale. It may also be called a business appraisal and has some similarities with real estate appraisals. A big difference is that much of business value is in the form of intangible assets, or goodwill. Valuing intangible assets involves a process of using various accepted valuation approaches and methods. The goal is to determine a value that can be explained and justified to others.

How Much is a Business Worth?

In theory a business is worth the present value of all the future benefits of owning the business. Present value is the process of discounting the value of cash or other property to be received in the future to its current value. There are many benefits (cash and non-cash) to owning a business. Valuation focuses on the financial benefits defined as earnings or cash flow. The rate at which the future benefits are discounted must account for all the risks associated with owning and operating the business. Basically the value of a business comes down to the classic investment paradox - risk vs. return.

Basic Valuation Methods

There are 3 primary approaches to valuing a business - market, income and asset. The market approach uses data from actual sales of similar businesses or from publicly traded companies to value a business. The market approach is the preferred method. The biggest problem is that good quality, comparable data is seldom available. The income approach looks at the earnings or cash flow of a business as the primary driver of its value. It is the most commonly used method and works well unless a business has little or no earnings. The asset approach tries to value each part (asset) of the business separately. The sum of the parts is the value of the business. This method works well with tangible assets, but not for the intangible ones. The methods of identifying and valuing individual intangible assets are highly theoretical and often produce unrealistic results. The asset approach is often used when a business has few intangible assets, or little or no earnings.

Conclusion

Knowing how much your business is worth is a critical piece of information that every business owner should know. The remaining parts of this series will explore and explain the business valuation process so you can do your own business valuation.