Business Valuation Methods
Financial statements do not reflect the value of intangible assets. For that reason, they are generally not a good reflection of the value of a business. Intangible assets that may not be reflected on company financial statements include such things as a customer base, proprietary lists, beneficial contracts, below market leases, patents and applications for patents, copyrights, trademarks and brand names, subscriptions and service contracts, franchise agreements, and in-house developed software. For this reason, a number of methods have been developed to estimate the value of a business. These valuation methods typically fall under one of three basic appraisal approaches: the asset approach, the market approach, or the income approach.
The asset approach uses appraisal methods that consist of a review of the individual assets and liabilities of the company. The most commonly used asset approach method is called the adjusted book value method. In this method, assets and liabilities are adjusted to a standard of value, for example fair market value. The major weakness of this method is that the value of intangible assets is not included. Occasionally, an appraiser may use an asset approach method in combination with a hybrid-method, such as the excess earnings method, to value the intangible assets of a company.
The market approach uses sales of businesses in the same or similar industries to develop valuation multiples that can be used to determine a value for the subject business. Several methods may be used—some use information from the sales of private companies; others use the price of public company stock to estimate the value of a subject company.
The income approach consists of two methods: the capitalization of cash flow method and the discounted cash flow method. These two methods are mutually exclusive. The basic difference between them is the assumption regarding growth. The capitalization of cash flow method can only be used if growth is expected to be consistent over a long period of time. The most difficult part of the income approach is estimating the discount or capitalization rate. A discount or capitalization rate measures the risk associated with investment in the subject company.
Some formulas exist to give businesses in a particular industry an easy, quick way to estimate a value. These formulas are generally referred to as rules of thumb. Rules of thumb usually provide a range of values. They are best used as checks for reasonableness instead of appraisal methods.
The appraiser must reconcile the various values determined from each appraisal method to determine a final value for the company.