There are three standard methods used to derive the value of a business. When calculated, each one will likely result in a different valuation, so an owner wanting to sell a business should use all three formulas and then decide what price to use. The valuation methods are:
- Market approach - sales based. Compare the company's revenue to the sale prices of other, similar companies that have sold recently. For example, a competitor has sales of $3,000,000 and is acquired for $1,500,000. This is a 0.5x sales multiple. So, if the owner's company has sales of $2,000,000, then the 0.5x multiple can be used to derive a market-based valuation of $1,000,000. However, there can be some problems with this approach. First, the company that has already been sold might have had substantially different cash flows or profits; or, the acquirer might have been paying a premium for the intellectual property or other valuable assets of the acquiree. Consequently, only use this valuation formula if the comparison company is quite similar to the owner's company.
- Market approach - profit based. Compare the company's profits to the sale prices of other, similar companies that have sold recently. For example, a competitor has profits of $100,000 and sells for $500,000. This is a 5x profit multiple. So, if the owner's company has profits of $300,000, then the 5x multiple can be used to derive a market-based valuation of $1,500,000. However, profits can be fudged with aggressive accounting, so it can make more sense to calculate a multiple of cash flows, rather than profits.
- Income approach. Create a forecast of the expected cash flows of the business for at least the next five years, and then derive the present value of those cash flows. This present value figure is the basis for a sale price. There can be many adjustments to the projected cash flows that can have a profound impact on the present value figure. For example, the owner may have been paying himself more than the market rate, so the acquirer will be able to replace him with a lower-cost manager - which increases the present value of the business. Or, the owner has not been paying enough for discretionary items, such as fixed asset replacements and maintenance, so these additional expenditures must be subtracted from the projected cash flows, resulting in a reduced present value. These types of issues can result in a significant amount of dickering over the valuation of a business.
- Asset approach. Calculate the market values of the company's assets and liabilities. Add to these amounts the assumed value of internally-generated intangible assets, such as product branding, customer lists, copyrights and trademarks. The sum total of these valuations is the basis for the value of the business. In many cases, the value of the intangible assets exceeds the value of the tangible assets, which can result in a major amount of arguing between the buyer and seller over the true value of these assets.
There is no perfect valuation formula. Each one has issues, so the buyer and seller can be expected to argue over the real value of the entity. The buyer will try to lower the valuation in order to generate some value from an acquisition, while the seller has an incentive to be overly optimistic in making projections and valuing assets.