The words “Business Value” or “Business Valuation” by themselves hold more than a singular definition. The complexity of business valuations, makes it challenging to fully grasp what is involved in the process of valuing a company. There are three main approaches when establishing a value for a company:
KEY FACTORS TO USING THE MARKET APPROACH
The market approach involves finding comparable sale transactions for other businesses in the same industry or finding comparable publicly traded companies to compare to the subject company. Below are important components to be included when using this business valuation approach.
IDENTIFYING AN INDUSTRY
Valuation analysts will start by determining the industry the business operates in. Understanding exactly what industry is critical to utilizing this method. Research begins by gaining a complete understanding of the business, the customers, products, markets, and competitors. After this information is collected, the next step is to identify the business NAICS and SIC codes. There are many generalized industries, including construction, wholesale, manufacturing, or information technology, but the valuation analysts will determine the correct industry classification within these broad industries. Finding the industry is important to utilize the correct comparable information.
MARKET RESEARCH & COMPARABLE COMPANIES
A significant amount of time is spent on market research and finding comparable companies. Valuation analysts start by using the business NAICS and SIC codes to search databases for comparable sales transactions.
Note: A common misconception is using this method is similar to a real estate appraisal. The misconception is, if a house is sold in the same general area, is a similar size, has comparable features, and is built around the same time it should have the same value. This may hold true for real estate, but businesses are more difficult when trying to compare.
Once the valuation analysts have a group of comparable companies, they research the transactions to determine if they truly are comparable. Most analysts will narrow the sample of businesses to five or 10 and conduct in-depth research on those businesses.
When pulling together a group of similar businesses from databases, zero in on the multiples of sales, earnings, or cash flow to develop an average multiple applying to business financial information. From the comparable transactions, valuation analysts will develop ratios of sales to selling price, cash flow to selling price, or earnings to the selling price. If using comparable public companies in the analysis, look at the ratios published in annual reports, such as price to earnings. Use the average price-earnings ratio to calculate the value of the business by applying the ratio to the net income. It is important to emphasize this method can only be used if there is an adequate sample size.
There are many reasons a company may want or need a business valuation, including negotiating a merger or business sale, estate, and gift tax planning, considering new shareholders, attempting to resolve partner or other liability disputes, determining shareholder equity, or even marital dissolution. A business valuation may also be useful for strategic planning and benchmarking purposes. Whatever purpose the valuation is fulfilling, it is vital to engage experienced professionals who will take a comprehensive view of all the company’s investments.