Charlotte County Option of Value | Florida Business Brokerage
It is often necessary to determine the value of a business, such as when courting investors or preparing it for sale. The specific process for determining the value of a business varies and can be achieved through a range of methods that we will review here. All of these methods fall under three common approaches that we will examine in detail.
Determining value based on assets alone is the most straightforward approach and has its roots in the basic principles of accounting. The overall theory rests on the principle of substitution, which attempts to determine the cost of completely replacing the business with one just like it. The key to this process is the balance sheet, a reflection of the total assets and liabilities of the business. A method for determining the value of these respective concepts must be chosen and consistently applied before the two values are subtracted from each other. The resulting value of the difference is the business valuation.
The most significant flaw with this process occurs when an asset isn’t reflected in the balance sheet, usually because it was developed internally or didn’t incur specific item costs. Oftentimes these ‘un-recorded’ assets will have significant value that isn’t reflected in the overall business valuation.
The market approach is perhaps the most realistic of the three options provided within this article, largely because it uses market forces to develop an idea of ‘fair market value’. This value can be determined by analyzing the price at which similar businesses are selling for and is presumed to be the value that a potential buyer would be willing to spend to acquire the business. Market data is the key to determining the critical numbers required for this approach.
The most significant drawback to this process occurs when your business is niche or particularly unique. Reliable market data will be significantly difficult to acquire in these circumstances, which will render a valuation utilizing this technique essentially useless.
The last approach in this list, the income method relies on a certain degree of speculation to determine a value. This method essentially attempts to determine how much income the business owner could reasonably expect in the future. As with any speculative process, there is a risk in this approach but it reflects the ‘reality on the ground’ better than the other two options described within this article. The costs and benefits of the business up to the point of sale are treated as moot and all eyes are on the future of the business, which is ultimately all a prospective buyer needs to be concerned with.
This particular approach requires an additional selection, as there is a need to determine the method for establishing expected income and risk. There are two different methods for doing this: Capitalization and Discounting.
The Capitalization method utilizes a Cost of Capital model to determine a capitalization rate. This rate represents the cost of acquiring the future capital the business will require to function and grow. This cost is then applied to the annual earnings of the business to determine the relationship between future business costs and expected earnings. As an example, a business with a 50% capitalization rate is worth twice its current annual earnings.
The Discounting method uses a variety of mathematical factors to establish a weighted risk for acquiring the business. It uses a risk-free return basis value (such as US Government treasury bond yield) and adds a variety of ‘premiums’, or penalties, to the business earnings that reflect specific risks over time. The result produced by this calculation is the terminal business value, which tells you how much it will be worth in the future. The current business value can then be derived from that number.
These three methods can often produce widely varying results for a given business because each of them focuses on different aspects or components of value. Realistically, each prospective buyer has different goals when acquiring a business and it’s worthwhile to determine which approach best reflects the values each buyer is looking for.