How many businesses have you started? How many businesses have you sold? If you are an investor who has bought, started, and sold many businesses, you likely understand the process of determining the value of any company.
Approximately 543,000 new businesses are opened every month. In contrast, just as many employer businesses shut down than start up each month. As all of these business opening and closing transactions take place, someone has to determine the value of these companies. Business valuations are determined by one of three approaches:
- valuation market approach
- income valuation approach
- cost evaluation approach
Valuation Market Approach Is Not Always an Absolute Number
Many factors go into determining the value of a company, but one popular method is the valuation market approach. This type of economic analysis is an exercise in understanding how one business compares to another. A business valuation report can take many things into consideration, including the purchase cost of other similar businesses, the number of similar businesses that exist within a predetermined area of the business, and the transactions of other similar private companies and public companies. By measuring a business against other similar businesses, potential buyers and sellers feel like they can get a good indication of the market value of a business.
A specific example might be if you would compare the value of a small boutique gift shop that is for sale to another gift shop that is located within a five mile radius. Find three similar businesses in that five mile radius and you might have an even better indicator of the market value. While things like number of employees, hours of operation, main street access, and parking may also effect the value, the initial valuation can be informative.
Income Valuation Approach Requires a Close Look at Financial Statements
The valuation income approach includes a close examination of specific reports: the company’s income statement and the company’s balance sheet. To reach the most accurate income valuation, it is best to have three to five years of historic income statements and balance sheets available. If, on the other hand, a business has only been operating for less than two years, the income sheets and balance sheets may not tell the entire story.
For instance, a company that had a phenomenal first year before two other competing business opened up close by, may have financial statements that are misleading. Both the buyer and the seller would need to look at the extra factors that could indicate the more true value of the business.
Cost Evaluation Approach Is the Third Way to Determine a Business’s Value
Business appraisal services also use the the cost evaluation approach to determine the buying or selling price of a company. This approach is also called the assets valuation approach. To determine the value of a business, this method requires a thorough inventory of what assets the company has. In the case of a business that has been closed for months because of the health of the owner, for example, the assets could be quite extensive. While the income for this type of business may not look like much, the unsold and already purchased inventory can combine to be very valuable assets.
Overall, the goal of any of these three methods is to avoid the over valuation of a business. To avoid this, it sometimes takes a close comparison of all three of these valuation approaches.