There are 3 basic approaches to value your business: the Asset Approach, the Income Approach and the Market Approach.
The Asset Approach is based on the principle of substitution. Meaning, it assumes that no prudent buyer / investor would pay more for a particular business than the cost to reproduce it right across the street. The main flaw with the Asset Approach is that it does not do a good job of capturing intangible value (goodwill). How you (and your employees) treat your customers and the reputation you hold in the marketplace is not something easily duplicated (and therefore valued with the Asset Approach). So, beware of the limitations of this approach. Understand that although an Asset Approach provides a relative indication of value for highly asset intensive companies, it may serve merely as a liquidation value for your service oriented company. The Income Approach and Market Approach do a much better job of fairly capturing the value of your company’s goodwill or intangible value.
The Income Approach operates under the assumption that a buyer will pay for the cash flow that your business is set up to produce going forward as of the date of sale. Buyers buy cash flow. How much they are willing to pay for access to your cash flow depends on the risk associated with the buyer actually receiving it once you exit the business. If your company shows a consistent history of steady cash flow and/or growth a buyer is likely to pay more for your cash flow stream (less risk) than for the cash flow stream of a similar company with unstable cash that cannot reasonably be assumed to reoccur in future periods (more risk).
By valuing the cash flow of your company you are inherently valuing EVERYTHING that your company does. If your company did something different (made different decisions or operated under a different philosophy) your cash flow would look different and the value of your business would be different. Your cash flow reflects all the decisions you make within your company. So, I challenge you with this question, if the decisions you are making don’t increase your cash flow (and buyers will pay you only for your cash flow) why are you engaging in those activities that don’t result in increased cash flow? They are not adding value to your company.
The third approach to value is the Market Approach. If you own a home or have rented an apartment, you’ve done a form of the Market Approach. When you compare and contrast similar properties and then use the comparative data to value your property, you are doing a Market Approach. In residential real estate you may compare things like price/sq.ft. or price/bedroom and price/bathroom. Once you obtain these ratios from similar properties you multiply the ratio by the square footage, the number of bathrooms, or the number of bedrooms in your home to get to a value for your property.
You can do the same thing with businesses. However, as you may have guessed, the value of your business is not driven by its square footage and its bathrooms. It is driven by other metrics such as revenue, assets, growth, leverage, turnover, liquidity, etc. Publicly traded companies and transactions involving other private industry participants provide an understanding of how price relates to the various financial metrics of these companies. Then, just like we did in valuing your property, we apply these market ratios to the metrics of your business to determine its market value.
Valuation is a complex matter with many intricacies that are not discussed here. The purpose of this article is to familiarize you with the basic valuation approaches employed. I don’t recommend that you attempt to value your business without the help of a qualified expert. But, I do encourage you to gain an understanding of these approaches so you can better focus on building value within your business before it is time to sell.