Co-author: Austin Potenza
Let’s say you’re looking to sell your leather manufacturing business. A buyer comes along and asks you to make her an offer. What’s the best way to determine the worth of your business? There isn’t one right formula. But here are a few common valuation techniques: (1) asset-based, (2) income-based, and (3) market comparable. The most appropriate method will depend on your company’s individual history, market, asset mix, and management strengths.
The most rudimentary method of valuing a business is valuing its assets and liabilities. At a minimum, a leather manufacturer has inventory and equipment, and these assets have value. In essence, this approach enables you to determine the cost of building a leather manufacturing business from scratch. But, depending on the nature of the business, the asset-based approach may result in a lower valuation, as it may not adequately take into consideration the intangible, going concern value of the business. For example, a services based business with valuable long term relationships may not be an asset rich balance sheet, in that the goodwill associated with the relationships may not be reflected on it. Nevertheless, the relationships may be a key factor in the value of the business.
The income-based approach determines the value of a business based on its income potential. It looks at cash flow, and does not place value on the fixed assets of the business. This valuation method is best suited for solid cash-generating businesses (i.e. businesses that are not asset intensive). The Discounted Cash Flow method is a subset of the income-based approach, and is often used in M&A transactions. This method, which is based on estimating the current value of future cash flow, is appropriate for businesses which have forecasted steady cash flow over several years.
The market comparable approach values your business using the average of similarly situated businesses in the same or similar industries. However, this approach can be risky because it may not capture the true value of your business. For instance, it is possible that the other similarly situated businesses sold at a lower price because of poor management, poor market share, lower than normal EBITDA, or other factors that would affect value and that may not be a problem for your business.
Bear in mind that all of the valuation techniques that are applied in the market must be used as either/or and not a combination. For example, if you are using Discounted Cash Flow, the tangible assets are not included in the calculation of your company’s value. Therefore, a leather manufacturer that owns and occupies a $1 million warehouse is going to be better off using the asset-based valuation method, whereas a professional services firm that expects to earn $1 million in profit next year, but has zero hard assets, will be better of using the income-based or the market comparable approach. Nonetheless, it may be a prudent idea to compute value using the different approaches to see what the results demonstrate.
There are many reasons for valuing a business even if you are not planning to sell. A valuation will help you understand your business’ weaknesses and strengths and continue to improve its real or perceived value. It can also help motivate your management team or benchmark its performance. If the team is compensated in part on the increase in business value, then measuring value regularly can keep them focused and motivated. Regular valuation is a good discipline and can help you take the necessary steps and make the necessary adjustments to generate the maximum value in an eventual sale.
About the Authors:
Shruti Gurudanti is an associate at May, Potenza, Baran & Gillespie, in the Corporate/Transactional Practice Group. Shruti is developing her practice in the area of mergers and acquisitions, emerging businesses and general corporate law.
Austin Potenza is a member of the Vistage Deal Network Advisory Board, a founding shareholder and attorney at May, Potenza, Baran & Gillespie, based in Phoenix. He is the head of the Corporate/Transactional Practice Group and his practice focuses on corporate law, commercial transactions, mergers and acquisitions, healthcare law, estate planning, and tax planning.