Business Valuation – Four Methodologies Used in Buying an Existing Business
Many entrepreneurs purchase a company already in existence, enticed by the advantages of an already running company. However, it is essential to look at a company’s valuation before completing any purchase, or even before considering the business as a viable transaction. What is the return on investment that the investor can expect? How is the business doing in sales? Can the investor expect to gain back the investment, and how long will it take to gain back the investment? Is the cash flow of the business enough to support the current debt or any proposed future debt? If the entrepreneur purchases the business utilizing debt, can that debt be paid back using the business’s profits? These are just some of the questions that can be answered by a thorough valuation analysis.
The following are a few methods credentialed valuation experts use to discover the actual valuation of a company.
- Multi-period Cash Flow Method
This methodology is used by investors who are knowledgeable about the business’ future or are knowledgeable about the relevant industry’s future. The multi-period cash flow method models a business’ cash flows 5 to 10 years into the future making educated assumptions regarding a business’ future sales penetration rate, market share and competitive landscape. These future cash flow expectations are then brought back to today’s dollars utilizing company and industry risks and long-term growth expectations all captured by a business’ discount rate.
- Capitalized Earning (Single Period) Method
Similar to the multi-period cash flow method, the capitalized earnings approach is used to determine the value of a business by calculating the net present value (NPV) of expected future profits as measured by cash flows. The capitalization of earnings method determines a single period cash flow (i.e., next year’s cash flow) and capitalizes that cash utilizing the capitalization rate (cap rate). This will take into account the risk that earnings will stop or be lower than the estimate. This method should only be used when there is an expectation of normal or consistent cash flows.
- Market Approach Method
This methodology is used by investors to determine the value of a business or an asset based on the selling price of similar businesses. In the real estate industry, a property’s value can be estimated by looking at comparable sales (i.e., recently sold properties that are similar in size and features and that are located within a close geographic proximity to the property being valued). In a business valuation, the market approach can be used to calculate the value of a business by identifying ‘like’ companies in similar industry’s and making adjustments for differences in size, entity type, management, etc.
- Assets Method
This methodology is used to determine a business’ value by estimating the value of all of an entity’s assets (net asset value) minus the net value of its liabilities. The asset-based approach basically asks what it would cost to recreate the business. This methodology can be useful if the assets and liabilities as carried on a business’ financial statements (book value) would be a good estimate of the assets fair market value.
Determining the value of a business is done by using one or a combination of these methods. An entrepreneur interested in purchasing a business should consider all of some of these methods to discover if the business is worth its asking price.