BASIC PRINCIPLES OF BUSINESS VALUATION

Valuing a business is as much an art as it is a science. There are a wide range of factors that go into the process - from the book value to a host of tangible and intangible elements, to the type of business and the reason for the interest in seeking a valuation. The quantitative portion of the project is the analysis of the company's financial statements. It will establish the company’s ability to generate profits. The amount and reliable consistency of the cash flow will determine its intangible “going concern” value.

It is reasonable for a buyer and seller to get completely different conclusions from the same set of financial analysis. A comprehensive valuation will use several relevant valuation approaches to determine a range of values from which the experienced preparer will choose that will best reflect the company’s value at the time it is being appraised. The buyer and the seller will probably negotiate a price that will fall within the parameters of the valuation which meets both the buyer’s and the seller’s needs and perception of value.
A qualified business valuation specialist or business appraiser, should be versed in your industry and have resources and experience to analyze and understand your business and the market place.

There are over 20 commonly used methods to value a business, 3 of the main categories are:

• Asset based valuations
• Capitalization of income based valuation
• Combination of Asset and capitalization of income

Asset Valuation

For company with high asset value, an Asset valuation is more advantageous. Businesses with high equipment and inventory assets, such as retail and wholesale distribution companies and heavy manufacturing will find this method to be more appropriate. This process takes into account the following figures, the sum of which determines the market value:
The market value of all equipment and machinery, if sold in an orderly manner.
The market value of real estate and / or value of the lease and leasehold improvements.
The market value of Inventory, including raw materials, work-in-process, and manufactured goods.
Any other assets the company has, including but limited to cash on hand.

Capitalization of income valuation

This method relies primarily on projected income stream of the business. The value of the company’s assets are not factored in the valuation. A company with no significant assets, such as a service business will likely choose this method.
The challenge this method will have is projection of future earnings. The farther one forecast, less reliable will the forecast become. The other decision is the capitalization rate, which will factor the variables that influence the risk of not realizing the cash stream. Each factor could have different wait in impacting your capitalization rate. Much is written about this subject, an experienced appraiser will use different values that reflects the marketplace. These are few significant factors.

• Number of years the company has been in business
• Consistency of the cash flow
• Quality of the Profits
• Industry’s risk factor
• Future potential for the industry
• Current and future of its Location
• Diversity and number of customers
• Consistency of Growth history
• Extent of Competition
• Barriers to entry
• Technological changes
• Owner’s reason to sell
• Significance of owner’s relationship with customers

Multiplier or market valuation for very small business – also called the rule of thumb method

This approach is usually used for smaller businesses run by an owner operator. It is not suitable for larger businesses or for situations that require economic justification of value. Although non-scientific, it reflects the market value for the typical business of a specific type in a specific industry. The multiplier is arrived at by the experience of businesses that have sold in the specific industry in a specific area. Since many small businesses do not have adequate financial data to analyze, the only available verifiable data is usually the gross sales. This method does not take into consideration the profitability, business expenses or other important factors that could make a business to be worth more or less. For a very small business, the multiplier may be one of the practical appraisal methods available.