November 2018 Business Sales Update: Business Valuation Methods
Thanks to Brodie and the Wellington team at Tabak Business Sales, we’re pleased to bring you Tabak’s top tips this month for business owners.
The process of valuing a business is both an art and a science. We take a look at data driven methods, and other factors at play.
Valuation approaches
There are three core approaches to business valuation. Within each approach there are a number of methods and some hybrids.
- Earnings-based methods determine probable future income of the business and capitalise this income stream to determine the business’s value. The adjusted or normalised income stream, which is the probable future income stream, can be determined by adjusting each revenue and expense item on the income statement. In profitable, closely held businesses, earnings-based methods are usually the best and most commonly used by valuers and other professionals.
- Asset-based methods include adjusting each asset and liability on the balance sheet to fair market value, and then the values are summed. This method is commonly used to determine a liquidation value or in a business situation where the value of the assets far exceeds the value of the business based on a capitalisation of earnings value. This approach ignores the earnings of a business and should receive minimal attention when valuing ongoing closely held businesses which generate earnings by selling products or rendering services.
- Market-based methods use data from comparable business sales to estimate the value of the business being appraised. After all, the market is the market. It may also involve using industry “rules of thumb”, where a prevailing formula exists for valuing businesses in a particular industry. Both methods provide an effective sanity check where other methods are being used.
Where art and science meet
Data driven business valuations are vitally important, but having a holistic view of the business is also critical. An understanding of the sector, market trends, the region and the business comparisons are crucial to provide an accurate business appraisal.