Understanding Business Valuations

Scott Park, CPA, CA

What is Business Valuation?

A business valuation is the process of determining what the economic value of a business or company is worth. There is generally no one single way to establish what a business is worth. That’s because business value can mean different things to different people.

For example, a business owner that has a good reputation and a regular clientele base within a local area or community may believe that their business is worth a lot based on this intangible factor. This type of customer loyalty factor is typically tied to the identity of the business owner, which makes valuing the business tricky. While a potential investor or buyer on the other hand may think that the business is worth a certain amount based solely on historical income and forecasted future cash flows.
 
There are many approaches when it comes to business valuations. Three different types are commonly used: the income approach, the asset-based approach, and the market approach.

Income Approach

The fundamental reason that business owners go into business is to earn a profit. Therefore, this approach looks at the economic benefits that are generated by the business and the future expectation of earning a profit. Since the business value must be established in the present tense, the future income and risk levels are estimated and then translated back to determine what the business is worth today.
 
The income approach uses two methods to translate the business value into today’s dollars: capitalization and discounting. The mechanics of how these methods impact the income approach will be discussed in a future blog.

Asset-Based Approach

Asset-based business valuations view the business as a set of assets and liabilities. These approaches can be done on a going concern basis or on a liquidation basis. A going concern asset-based approach looks at the net assets of the business (assets minus liabilities). A liquidation asset-based approach determines the net cash that would be received if all the assets were sold and liabilities were paid off. 

Market Approach

 ​The market approach, as the name implies, attempts to determine what a business is worth by comparing a business to a similar business that has recently sold. This approach only works well if there are an adequate number of similar businesses to compare.
 
This approach is a great way to determine what is known as fair market value (FMV). FMV is an estimate of the market value that a knowledgeable, willing, and unpressured buyer would pay to a knowledgeable, willing, and unpressured seller in an arm’s length transaction.

Why Is Business Valuation Important?

There are many reasons why having a business valuation is important. The fact is that many business owners in Canada are over the age of 50 known as the Baby Boomer demographic. There comes a point in time when serious consideration needs to be made about selling their business, transitioning their business within their family, or closing their business and walking away. Other reasons to have an up to date business valuation done may include: debt or equity financing opportunities, bringing in potential investors into the business, adding shareholders, shareholder or partnership disputes, shareholder or partnership buyouts, corporate re-organizations for tax purposes, to determine the value of assets in a marital separation dispute, to value a business for business bankruptcy, to determine the annual per share value of an Employee Stock Ownership Plan (ESOP) etc.
 
A well prepared business will have a greater likelihood of being sold as well as being able to command   a higher selling price. An accounting and business valuation professional will be able to assist current and prospective business-owner clients in helping them recognize the following issues for serious consideration:

• The future is fast approaching
• Their business may not be worth as much as they thought. This is called the value gap – the difference between what the owner expects or needs the business to be worth versus what it is actually worth today

• An accounting and business valuation professional can help build the value they desire before a decision is ultimately made

 

Disclaimer: The blogs posted on Scott Park & Co Inc. website provide information of a general nature. These blog posts should not be considered specific advice since each person's personal financial situation is unique and fact specific. Please contact us prior to implementing or acting upon any of the information contained in one of our blogs.