Companies are not comprised solely of hard assets like buildings and products, intangible factors such as intellectual property, brand status or business reputation should be factored into the equation.
Business brokers use various formulas to calculate the value of a business. The valuation approach they apply depends on the type of industry, nature of business, company size and other particular circumstances.
The start-up cost method computes the initial outlay invested in the business. Entry expenses include purchase or lease of the premises, facilities, employee training, product development, advertising, building market share, etc. This itemised approach attaches a monetary value to hard assets, but fails to account for the intangible components that the owner puts in to establish the business and nurture its growth.
Multiplier valuation by sales
This valuation applies the multiplier method to estimate how much a business is worth. Average sales figures in a particular industry may be used to arrive at a standard multiplier factor. Trade or financial publications, industry associations and business brokers are common resources of current multiples used per industry.
The basic formula is a company's gross sales times the multiplier; for example, $50,000 gross sales x 0.25 multiplier = $12,500 value of the business. The formula may be modified by adding other components to the equation. For a retail business, the value of its inventory is added to gross sales before multiplying it by the industry multiple.
However, the stock may be overpriced, as in the case of fashion merchandise whose value declines at the end of the season.
The validity of the industry standard multiplier is questionable because this basis alone does not give the complete financial picture. Companies across an industry vary by size, scope of operations, production output, market share or brand value. Moreover, a host of other differentiating factors, such as cash flow and profitability, are not taken into account.
Multiplier valuation by profits
Alternatively, the multiplier number may be based on a company's profits. The price to earnings ratio can range from five to ten times the after-tax profit. Small businesses will fall into the lower range, while enterprises with better prospects will be assigned a higher multiple.
Business income valuation seems straightforward and easy to understand, since it uses recent profitability numbers as the benchmark. However, the reported return on investment may not reflect an accurate financial status or looming external threats.
Earnings can be overstated by deliberately pending a necessary capital investment. The actual profit margin should not be as high as claimed if the owner has drawn a salary for managing the business. Deducting the manager's compensation will result in a more realistic figure. A rival business may set up shop in town, lure customers away and take a big bite of the profit pie.
Valuation by asset or adjusted book value
This method uses the simple formula of total assets less total liabilities on the balance sheet. It is often applied to companies with considerable tangible assets, such as real estate properties. This approach can be misleading if the book value of assets such as buildings and equipment is inflated.
The problem can be addressed by adjusting the book value to factor in asset depreciation and maintenance or replacement expenses. Fluctuations in market price of real estate should also be considered.
Variations to the formula include tangible, economic or liquidation value. Tangible book value is calculated as total assets minus soft assets. Economic book value comprises both tangible and intangible assets and adjusts their values according to current market prices. The liquidation value method subtracts a company's liabilities from the value of its assets at liquidation.
Discounted cash flow
Discounted cash flow valuation is appropriate for start-up web-based companies that have growth potential but lack hard assets and a financial track record. The method deducts intangible criteria from projected cash flows or NPV (net present value).
One component that bears on forecasted cash flows is the time value of money, equivalent to the period it takes for the purchaser to recoup his investment. Risk premium should also be factored in as insurance in the event that future cash flows are not realised.
The foregoing formulas are just common examples. In actual practice, business brokers and professional valuators use diverse valuation methods to fit specific situations.
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