A common question that we hear from our clients is “how do I value my business?” While there isn’t necessarily a simple answer to this question, there are some basic valuation approaches to consider based on the nature of the business. These approaches fall into one of the following categories:
- Asset Based Valuation
- Market-Based Valuation
- Return Based Valuation
As the name suggests, “asset based valuations” determines value based on the underlying value of the net assets (i.e. considering assets net of any liabilities) of a business or entity without any necessary consideration of the business’ future earnings capacity. This approach is generally used in one of three situations:
- For investment holding companies or businesses without active operations, as the underlying asset values constitute the prime determinant of value.
- For businesses that are not profitable or are not providing a sufficient return on investment given the risks involved.
- For businesses within certain industries where potential buyers do not perceive any value for goodwill due to the nature of the business. Examples include certain medical practices where the goodwill is tied to the individual doctor or businesses within the construction industry whose revenues are generated via tender bid processes as opposed to the name and reputation of the business.
Market-based valuations are approaches that determine value based on some form of market comparable transaction. These approaches would include using some form of implied multiple (e.g. a ratio of value to revenue) from comparable public companies or known purchase and sale transactions within the industry and applying that multiple to the metrics of the business being valued. Another form of this approach is what is known as “Rules of Thumb” which are common, and usually simple, valuation models within a particular industry. For example, businesses within the insurance industry are commonly valued based on a multiple of the last twelve months of commission income generated by the business. The “multiple” that gets applied is dependent on the nature of the insurance being sold and the level of transaction activity happening at that particular point in time.
The last, and most common approach, to valuing a business is return based valuations. This approach is generally used for operating businesses where the value of the business goes beyond the net assets because there is a goodwill or intangible value associated with the business’ reputation, brand, customer list or some other factor. This approach considers both the expected future earnings prospects of a business and the risks relative to those future prospects and applies the mathematical concept of present value to value the business. In their simplest form, the application of this approach is achieved by applying a multiple to the earnings or cash flows being generated by the business with the multiple determined based on the risks associated with the business. When you hear of businesses being sold based on a “multiple of EBITDA” (earnings before interest, taxes, depreciation and amortization) then this is effectively a return based valuation approach being used. While this approach might sound simple, return based valuations are definitely the most difficult of the approaches to apply in practice as the calculations do go beyond just multiplying the earnings of a business. Considerations of the appropriate multiple, whether there are any redundant or non-operating assets and the appropriate financing structure of the business are just a few of the complicating factors that need to be addressed.
At the end of the day, the nature of the business and the industry in which the business operates are the main driving factors behind which approach is most appropriate. Hopefully the descriptions above have provided a high level overview of the different approaches that might apply and, consequently, provide you with a starting point to the valuation of your business.