There are many reasons why you might decide to get a formal valuation of your business. Whether you are considering selling, merging or expanding your business, industry experts like John Kleinheinz can tell you that the critical first step is to understand the different ways that the value of a business can be determined. Each of these approaches has its own strengths and weaknesses which should be fully understood so that you can decide on the best method for you to suit your particular needs and situation.
A common way to determine the value of a business is by estimating the business’ anticipated future earnings. Obviously, there is a degree of guess work involved, and any such estimations must take account of market and business trends going forward. Some ways to calculate this will look strictly at expected trends, and others will extrapolate based on past earnings to get an average. Clearly, the value will depend on whether you take an optimistic or pessimistic view of future conditions, and you could find yourself with a business that has been over or under-valued. The advantage of this method is that it determines a value based on a reasonable expectation of worth in the coming period, and is especially useful if the company is poised to introduce new technology or open in new markets.
Asset-based approaches to valuing a business seem to be the most objective in that they don’t rely on predictions about future trends, and because most assets (but not all) can be quantified in dollar terms. Asset-based approaches determine the value of a business based on the assets it holds minus any liabilities. Assets include property, equipment, bank accounts and other assets, and liabilities generally refers to debts or accounts owing. While it seems quite straight-forward, it can sometimes be difficult to get an accurate accounting of assets if the business in question is a sole proprietorship. This is because sole proprietors may be using assets for both business and personal use. It is also hard to attach a dollar amount to intangible assets like brand recognition or reputation.
This approach may be the most intuitive approach to valuing your business in that it is a measure of what people are willing to pay. In that sense, there is a fairly objective component in that there are quantifiable assets. But this approach also creates space for the intangible assets in your business. For example, your business might have an exceptional reputation, or extremely loyal customers or staff. It might be located in an area that is expected to “boom.” It can be somewhat difficult to gauge what people will pay, however, without entering the market or finding out what a comparable business sold for recently. This approach can be of great use because it balances the question of what people are willing to pay for your business against an accounting of its assets and liabilities or its anticipated income. For example, you might find that your assets have value of X dollars but that people are willing to pay much more than their current worth to acquire them. Or, you might find that despite predictions of high income over the next year, no one is willing to pay for that promise in the present.
Clearly, each of these approaches has strengths and weaknesses. For this reason, you should consider using each approach to establish the range of possibilities rather than taking the evaluation from any single method on its own.