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Business Valuation in America

Business valuation is a methodology and set of principles used to examine and estimate all associated economic factors of a business by using a predetermined formula to asses the value of the business or the owner’s vested interest in the business. A business valuation will be conducted to get a snap shot idea of the current business financials and viability of the future business. It is used by buyers, sellers, and financial institutions to determine the fair market value of the business or to lend on the business.

Why are there valuations?

As we say, beauty is in the eye of the beholder. Buyers and entrepreneurs want to buy or own a good and profitable business. However, in reality, some entrepreneurs or buyers want to buy a business which is well managed and has a positive cash flow with room for future expansion. Some entrepreneurs or buyers look for an opportunity where a business is in trouble or is going to be in trouble so that they can turn that business into a profitable one by using their skills and experience. No matter what, when they plan to buy a business, they want to offer a price based on the business value.

Value Versus Worth

Business worth is a market value of the business given by the appraiser/broker/other valuation professional based on a combination of tangible and non-tangible assets. Value is the income generated by the particular business without considering the fixed assets. Surprisingly, in the market it is very common to see business value higher than worth and vice versa.

Fair Market Value

This is the value of a business or an asset where the buyers and sellers are exchanging in the current market, i.e. willingness or offer of the buyer, and acceptance of the by the seller.

Factors that influence fair market value:

  • Cash flow based on the seller’s financial documents
  • Volume of the business
  • Profit margins of the business
  • Gross profit
  • Net profit
  • Operating expense
  • Debt to income ratio or debt service
  • Tangible asset value such as furniture, fixtures, and equipment
  • Operating hours
  • Type of licenses and status
  • Lease period and options
  • Zoning changes
  • Location of the business
  • Area of the business
  • Type of customer
  • Services offered
  • Future expansions
  • Viability of the business
  • Employee role
  • Management and technology usage

These are a few important factors that affect the fair market value. In addition to these, there are many factors that will impact the value of a business and their influence will vary from business to business and location to location.

Fundamental calculation of business valuations methods

Asset Approach Method

The asset approach method is also known as the cost approach method and is used to know the business value based on the value of the business assets. The basic idea is to ascertain the business value based on the fair market value after subtracting the liabilities, i.e. business assets minus business liabilities. All tangible assets are counted for valuation purposes. Sometimes this method may not be accurate as it is very hard to find the value of some of the tangible assets such as good will, etc.

The cost of substituting or replacing each asset is determined individually. The common asset-based methods are

  • Adjusted book value method
  • Liquidation value method and
  • Replacement cost method.

This method is useful when the business assets prove more valuable than business values derived from the other methods.

Market Approach Method

The market approach method to business valuation is rooted in the economic principle of competition. This method is used to find the business value based on current market trends, market sale, going rate, or sales of comparable businesses. This type of business valuation relies on the current market sales or comparable sales in the given geographical area.

As this is valuations is based on the comparable sales, the business value depends on the supply and demand of that business in a given geographical area.

Income Approach Method

The income approach method to business valuation is rooted in the economic principle of earning or cash flow. This method of business valuation is determined by the income generation or cash flow of the given business in order to satisfy the economic benefits of the owners or the investors. The economic benefits of the owner or investors are seller discretionary earnings (SDE) or net cash (NC) flow and are capitalized and discounted to perform the valuations.

Here are the common approaches for such capitalizations

  • Discounted future cash flow (DFCF)
  • Capitalization earning method (CEM)
  • Multiple of discretionary earnings (MDE)

Common Factors in the Market

These business values are generated by the buyers and sellers based on their businesses operation experiences

  • 2 to 4 times of seller net operating income
  • Fair market value of the furniture, fixtures, and equipment
  • Type of lease and lease conditions
  • Value of the licenses and permits
  • Risk of the business
  • Nature of the business
  • Type of business
  • Viability of the business
  • Geographical area
  • Other associated factors of the business

There is no single parameter for why and how the buyer and seller got their values and prices; however we understand that it is usually based on supply and demand. Also all other associated factors for the sale or transfer of the ownership of the business are considered.

If have a question about business valuation, want to know more about American business valuation methods, or have further questions about valuation, please contact us at help@bizworldusa.com or 415-234-8833 and one of our approved third party business valuation professionals will contact you.