Call SB Partners 905-632-5978

Business Valuations

Business Valuation Models – The What and Why

Is the ‘whole’ greater than the sum of its parts?

Having devoted time, money, and energy on starting and growing a business often creates a set of expectations for an owner on the value of their business that is skewed.

Those expectations can go both ways as some owners have sky high expectations that are reflective of the blood, sweat and tears they have invested in their business while others place little value on the business they have built.

The purpose for which an owner may be looking to understand value can also skew those perceptions with a potential sale obviously leading to a bias towards the sky-high expectation side of things. On the contrary, a business owner dealing with a matrimonial separation or divorce, will be prejudiced to a lower value for their business. Either way, and regardless of the purpose of the valuation, it is important that business owners understand the true fair market value of their business from the perspective of a potential buyer along with understanding how a buyer, either real or theoretical, will approach the valuation of their business.

There are three main methods used to value a business and choosing the right method is contingent on several factors including but not limited too economic conditions, industry trends and standards, consideration of both the historic and projected earnings of the subject asset, and the presence of commercial (transferrable) goodwill and intangible assets in comparison to personal goodwill.

When we sit down with a business owner to discuss operations and inform them of the valuation methodology that is most applicable, we tell them that our decision is based on assessing and considering the viewpoint of a potential buyer (strategic buyer – i.e. a competitor versus a financial buyer – Private Equity Firm), in conjunction with the implicit characteristics of the business and external factors (economy, political climate, industry regulations etc.).

If you were to survey corporate finance and/or valuation experts they would likely argue that the most important factors in deciding an appropriate valuation methodology are considering the magnitude of the company’s earnings, the subject company’s stage in its life cycle at the time of valuation (i.e. start-up versus stable and mature) and whether there is personal goodwill or commercial goodwill.

Having considered this information there are three options to choose from. Business valuators will select from one or more of the following approaches:

  1. Asset based approach;
  2. Earnings (Returns) based approach;
  3. or a Market-based approach.

Asset-based Approach

What is it?

An asset-based approach generally looks at all of the assets of a subject company, adds up the market value of these assets which are then reduced by the market value of all of the company’s liabilities at the valuation date. There is less of a focus on earnings or cash flows as they are either negative or nominal in magnitude and lower than the value of the net assets of the company (i.e. realizing on the value of the assets by selling them yields a greater value than applying a multiple to an insignificant level of earnings or cashflows).

When is it the best choice?

An asset-based approach is suitable for businesses that are light on profitability but ‘asset rich’. Their value is predicated on the market value of its tangible assets that they own, net of liabilities, over their ability to generate revenues and profits.

More often than not, the market value of certain companies who have valuable investments in real estate, marketable securities, property, and equipment make up the lion’s share of the value to be found in the subject company being valued.

The other situation where this approach is relevant is where the business is primarily dependent on the owner or another individual working in the business. In these circumstances, while there may be solid profitability, a buyer will not be willing to pay more than the net tangible asset value because any goodwill of the business is personal in nature and tied to that individual.

To summarize, companies that find themselves in a declining industry, generating little profitability, with nominal future prospects, or reliant on an individual working in the business are typically valued using an asset-based approach. The attractiveness of the company to prospective buyers is not in the future earnings of the company, but in the current tangible assets owned.

Earnings (Returns) based Approach

What is it?

An earnings or returns-based approach takes a critical look at past and future performance of the company’s ability to generate earnings or cash flows. This is particularly applicable when the future expected earnings are significant and suggest that the subject company is earning a return on the assets that are used in its operations.

Ultimately a buyer is interested in acquiring the future expected stream of earnings/cash flow, as this is a key tenet of valuation and is the basis for determining the value of any cash generating asset. Unless the magnitude of earnings/cash flows is nominal which would result in the application of an Asset Based Approach as previously indicated.

Within the Earnings or Returns-based Approach there are a few different methodologies depending on the situation and these methods that are applied in a returns-based approach include:

  1. Capitalized Earnings Method (CE Method) – Reported earnings for a representative period of preceding years are examined and adjusted for non-recurring, seasonality, unusual, and extraordinary items that would distort an estimate of future earnings.These adjustments are often referred to as ‘normalization adjustments’. The adjusted earnings are then multiplied (capitalized) by a multiplier to derive the capitalized earnings value of the subject company. The multiplier that is applied is a function of the risk reward specific characteristics of the subject company and the industry and economy in which it operates.
  2. Capitalized Cash Flow (CCF) Method – this method is similar to the CE method; except it goes a “step further’ by adjusting earnings for non-cash items such as amortization, depreciation, deferred income taxes, as well as normalization adjustments impact on reported earnings are eliminated to show ‘adjusted cash flows’.The adjusted cash flows are further refined into ‘free cash flow’, which is the expected cash flows of the business reduced for capital asset purchases and working capital requirements. Once the free cash flow is determined a multiple is applied to determine the market value of the operations of the company.
  3. Discounted Cash Flow (DCF) Method – Projected future earnings or cash flows are discounted by a desired rate of return which considers several factors (external and internal) relating to the business being valued as well as the time-value of money. The rate of return takes into consideration the various risks attached to and the opportunity costs of acquiring the business.The DCF method is generally appropriate in situations where the company’s cash flows can be reasonably estimated and are expected to differ significantly from the current situation (i.e. cessation or sale of a portion of a business, expansion capacity, or a significant change in management, business strategy/product or service offerings or the company has a finite life).

When is it the best choice?

It is the best choice when the subject company generates significant earnings or cash flows, thereby earning a return on assets and the business has commercial goodwill and intangible assets (i.e. not personal goodwill). It is suitable when the value of the business includes returns from both intangible assets and tangible assets employed.

Market-Based Approach

What is it?

Similar to listing real estate based on comparable properties sold, the value of a business using a market approach is determined by comparing the subject company to similar businesses, business ownership interests, and securities that have been sold. This is achieved through:

  1. The Guideline Public Company Method where market multiples are derived from market prices of actively traded stocks on an exchange of companies that are engaged in the same or similar lines of business.
  2. The Merger and Acquisition Method where valuation metrics are derived from open market transactions of the ownership interests in companies that are engaged in the same or similar lines of business.
  3. Analysis of prior transactions of ownership interests by analyzing any prior transactions in the ownership of the company within a reasonable timeframe from the valuation date.

When is it the best choice?

This approach is mostly used as a secondary approach due to its limitations (often comparable companies are similar but not exact matches). As a result, in practice the market approach is often used to corroborate a valuation conclusion determined using an income approach as the primary approach.

The market approach is less likely to be used for sole-proprietorships or where there are limited comparable businesses in the industry. Because the market-based approach works on averages, it is worth considering whether the business being evaluated performs at an average rate for the industry, excels in the industry, or is operating at a lower level than competitors. A business outperforming in an industry may be disappointed with a valuation benched at industry averages.

With so much at stake in the sale of a business, obtaining a professional valuation is a sound investment. It is often difficult for business owners to objectively assess and set out to realize the value of the company. Different methods are applicable for businesses at different stages of growth and ownership.

Moreover, in the context of a matrimonial breakdown, understanding the driving forces in applying the correct valuation approach is critical to accepting the conclusions reached by the valuator on the value of the business. Quite often the soon-to-be exes and often the non-business owning spouse believes that the business is worth more than it actual is as they believe that there is value that can be maintained by a purchaser, when in reality the business success is tied to the traits of the owner (spouse owning the business) which is not an asset of the company but rather value to the owner.

The results of a valuation may be surprising and often identify areas for improving value by focusing on key-value drivers. For more information and the next steps, contact our team. We will guide you to understand the approach that should be applied and result in a proper conclusion of value.

We have detected that you are using an outdated browser.

Upgrade to a newer browser for a better experience.

Download Edge