Business valuation is an essential practice that is critical at many stages in the life of a company. The most obvious role of business valuation is to provide useful assessment that can help set the sale price of a company when the owner intends to exit.

However, business valuation is also relevant in a number of other circumstances, including offering support for estate planning, planning for future investments in growth, supporting the merger and acquisition process, and creating a clear succession plan.

With that in mind, it’s important to consider and understand the essentials of the business valuation process. In a previous article, we discussed key factors used in business valuation. In this article, we’ll explore three of the most common methods used to perform a business valuation. They are:

Asset-Based Method

In this relatively simple method, the value of the business constitutes the total value of the company’s tangible and intangible assets collectively. The greatest challenge in this method is that it ignores the company’s potential for future earnings, which is why it is most commonly used for entities that are not currently going concerns (defunct or liquidated enterprises), or those that are likely to wind down soon. A variation of this method is known as adjusted book-value.

Earnings Multiplier Method

For a company that is expected to maintain viability into the future and even achieve ongoing growth, the earnings multiplier method is the most common model. It examines the company’s future earning potential and assigns a multiplier on that basis, thus providing an informed estimate of return-on-investment (ROI) for the potential buyer. The challenge in this model is to establish a multiplier that works for both buyer and seller, a challenge that most commonly resolved by the valuation specialist or business broker examining comparable sales for similar companies (“comps”).

Debt-Paying Ability

Another method used in part to develop a clear valuation is debt-paying ability. Buyers often finance a high percentage of the acquisition process often 65-80% of the total price. Therefore, it is essential that the business itself be in a position to support that debt service, plus the return on equity invested and the salary or other distributions to the new owner(s).

There are many other methods and techniques used in the business valuation process, but these provide a solid starting point for understanding key factors that go into the process.

To begin exploring and determining a clear fair-market value for your business, discuss your current and future plans and objectives with your CPA today.

Selected Sources:

• Demystifying Small Business Valuation
• Seven things that determine the value of a business
• Business Valuation Methods
• Is It Worth Getting a Valuation for Your Small Business?
• Why Do You Need a Business Valuation?

Image Credit: drewleavy (Flickr @ Creative Commons)