Active and Passive Appreciation
Business Valuation Approaches
Business Valuation requires an understanding and application of appropriate techniques. Revenue Rulings issued by the IRS describe the factors and approaches to be considered while valuing businesses. Three main approaches used in business valuation are the Income, Asset, and Market Approaches. Within each of the approaches the appraiser has to select specific methods appropriate for the purpose of valuation. A brief description of these approaches follows.
Income based valuation
Income based methods are used for valuing the business as a continuing entity. The analysis is based on the ability of a business to generate income and the degree of risk assumed by the owners. This valuation method is best used for non-asset intensive businesses.
Two variations of the basic capitalization are commonly applied. Capitalization of future income stream based on the accounting cash flows of the firm is considered appropriate where a firm is managed by non-owner professional managers. Capitalization of discretionary cash flows, adjusted for all personal benefits provided by the business, in addition to the accounting cash flows generated by the business, is considered more appropriate in case of owner-managers.
The following factors are commonly used by an appraiser to determine an appropriate "capitalization rate" which is used to compute the market value of the business based on the income or cash flows of the business.
 | Length of time the company has been in business |
| Known risk factors |
| Profitability achieved by the business |
| Growth history and potential |
| Competition faced by the business |
| Entry barriers for potential competitors |
| Established Customer base |
| Uniqueness of Technology |
Asset based Valuation
Asset based methods focus on the value of a firm's assets rather than the expected cash flows. This approach is considered appropriate when a business is asset-intensive. Retail businesses and established manufacturing companies without substantial growth prospects fall into this category. This process considers the following factors to calculate the market value of the business.
| Fair market value of fixed assets and equipment (FMV/FA) - This is the price you would pay on the open market to purchase the assets or equipment, as distinct from the book value of these assets. A qualified machinery appraiser, familiar with the industry is usually retained to provide these values. |
| Leasehold improvements (LI) - These are the changes to the physical property that would be considered part of the property if you were to sell it or not renew a lease. |
| Inventory (I) - Wholesale value of inventory, including raw materials, work-in-progress, and finished goods or products. |
| The sum of these assets is reduced by the amount of the Outstanding liabilities of the business. |
Market based or Multiplier valuation
This approach values a business by using an "industry average" rule of thumb multiplier. This industry average number is usually based on the ratio of price paid and revenue, profit, or asset values for comparable businesses in recent transactions. This is a rather ad-hoc approach as it tends to disregard the differences between businesses in the same industry. It is also difficult to identify exact comparables for the business being valued. At best this approach is useful as a sanity check for valuations derived from income or asset based approaches.
Sales transaction data are usually available from the industry trade association or from publications.
Business Valuation LLC can help to develop valuation models and illustrate the impact of different valuation strategies for your clients. contact us.