Tuesday, November 27, 2007

The Basics of Business Valuation

So you want a small business loan to purchase a new business. You need to know some outlines of how the professional hired by you would reach the value to correctly apply for funding for that small business you want to purchase. A valuation professional may use the techniques discussed below to develop a range of values. Different techniques might result in different values.

Asset Based Valuation:

Book value—It is the difference between total assets and total liabilities, better known as net worth. But it does not really indicate market value of the business.

Net adjusted value—In this method firm’s assets and liabilities are calibrated to current market value, giving adjusted book value. Again, it doesn’t correspond to actual market value.

Liquidation value—The estimation of the company assets’ worth, when sold at auction or a distressed sale.

These methods are rarely used because they don’t factor in future potential earnings and more often than not produce minimum values.

Income Based Valuation:

Capitalization of earnings— This method arrives at the assumed value of the business by dividing previous year(s) normalized net earnings by assumed capitalization rate. The perception of risk determines the cap rate used.

Discounted future earnings—In this method, present value is calculated discounting several years’ (perhaps five) future net earnings estimates. The sum of the present values may equal the assumed value of the business.

Again, the discount rate used reflects the perception of risk associated with the purchase.

Generally size, risk, profitability, and liquidity affect capitalization and discount rates.

Market Comparison Method: In this method the subject small company you want funding for is measured against the selling prices of similar companies on numerous parameters, such as industry, size, and location.

Rules of Thumb Method: In this method suggested selling price is arrived by calculating the firm’s annual sales/earnings (usually normalized) multiplied by an assumed multiple.

These are some commonly used business valuation methods. Purpose or reason for determining value may result in use of one or more techniques. The size of business is good indicator of the method to be used.

You must get the professional to clearly explain the valuation method used and its justification. The reasoning behind the pricing is critical for evaluating the personal risk involved and to successfully apply for New Business Loans.


Karen Bowery said...

Nice post. I'll keep it in mind because I plan on running a business soon. I've been thinking about it for a long time now, and I can use all the help and advice I can get. Anyway, lately I've been thinking about buying a business instead of starting one from scratch. Any suggestions? Advice? Thanks.

Jamie Stanton said...

@Karen -- There are a bunch of resources online you could check out. There's one called BizTrader.com. It's an online global marketplace where you can buy or sell a business. It also has helpful tips and advice, and you can use it to find professional help, like a lender or broker.

Then there are always books you can read and local small business groups that can be very invaluable.

Good luck!