The Three Types of Business Valuations
The Key Factors in Business Valuation
To properly value a business, one must first look into the past. This means all historical financial statements, such as income statements, balance sheets, statements of cash flows, and tax returns, should be evaluated to understand what the business has done historically. Interviews are often conducted within the business’s management team to achieve a more holistic view of the business. Human capital, strengths and weaknesses, competition, growth trajectories, and industry type are all factored into a business valuation.
Understanding the Three Main Approaches
There are three main types of business valuations, each with their own sub-approaches: the income approach, the market approach, and the asset approach.
The income approach relies heavily on normalized historical earnings —and works best for stabilized companies with deep histories. If the company is in a period of transition or transformation, it may be more beneficial for the management team to create growth forecasts, which are then discounted back to present value to achieve a more accurate value.
The market approach looks at sales of comparable companies to infer value. It is also possible to analyze these comparable companies’ stock prices and other publicly reported data if the company has not been sold to see how the market has valued the company.
The asset approach is typically used when a company’s asset value exceeds its cash flow value. This method values a business based on both its tangible and intangible assets.
Valuation Discounts
There are two main types of valuation discounts: lack of control and lack of marketability. The discount for lack of control reflects the advantages and disadvantages of having decision-making authority versus not having it. For example, a minority owner without control cannot set salaries, distribute bonuses, or make other high-level decisions. This lack of control creates a risk of being excluded from earnings, making it essential to quantify marketability.
The lack of a marketability discount reflects the difference in transferability between private stock and publicly traded stock. Several factors influence marketability, including a company’s financial strength, management quality, dividend issuance, and transferability restrictions. For example, a company with strong financial statements, experienced management, regular dividends, and no transferability restrictions would be considered highly marketable.
Understanding Valuation Standards
The purpose of a valuation determines the standard of value used. The most common standard is fair market value, which represents the price agreed upon by a willing buyer and a willing seller, both having equal knowledge of the facts and neither being under any pressure to act. This definition ensures a level playing field. Additionally, marketability discounts may apply under this standard.
Another common standard is fair value, which is essentially fair market value but without any discounts. Investment value refers to the worth of an asset to a specific buyer, considering their unique circumstances or strategic interests. Lastly, liquidation value applies when a company is forced to sell its assets or shut down, often resulting in lower valuations due to the urgency of the sale.
At Hantzmon Wiebel, we understand that business valuations can be complex. Fortunately, our team of highly qualified CPAs, ABVs, and accountants are here to help. We provide accurate, detailed reports to determine your business’s true value.
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Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this blog are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.
