Business Valuation Methods: Arriving at a Listing Price

Publication date: February 7, 2006

A key task in selling any business is deciding how much it is worth. Determining the fair market value of your business is an involved and complicated process which includes the analyses of many variables. Once we are in possession of certain information and documentation, we will apply advanced business valuation methods to arrive at an appropriate value of your business and a suggested listing price.

Although there are many business valuation methods that can be used when estimating the value of a business, they tend to group within three possible approaches:

- Asset Based Valuation
- Market Comparison Valuation
- Income Based Valuation

We utilize the most commonly used (and most appropriate business valuation method) approach for a small business (defined as a business with annual sales of $5 million or less) - an Income Based Valuation.

The Income Based Valuation approach is further broken down into four generally accepted methods as follows:

- Present Value of Future Earnings
- Gross Revenue Multiples
- Capitalization of Excess Earnings
- Multiple of Discretionary Earnings

The business valuation method applied by us for your business will likely be a combination of both the widely used and professionally accepted Capitalization of Excess Earnings method and the Multiple of Discretionary Earnings method. This is a powerful way of estimating the value of a business that allows it to be fairly valued as an investment opportunity without many of the uncertainties that other business valuation methods introduce. This method assumes that a business owner is entitled to a fair return on the value of the business (his/her investment) over and above his/her fair wage (if the owner(s) works in the business). This combined approach will assign a financial value to the company’s reconstructed earnings (resulting in available discretionary earnings) that are reflective of the risk associated with the continued operation of the business in light of recent proven financial results that can reasonably be expected to continue after the business purchase for an indefinite but substantial duration.

Using the two business valuation methods described above also enables us to calculate the goodwill value in the business as well as its estimated fair market valuation. Furthermore, this approach works equally well whether the business to be purchased is operating as a sole proprietorship, partnership or as a corporation. Thus, these business valuation methods are based on the income a business has proven it can earn with the expectation being that the recent level of actual earnings of the business will continue at or above that level for some reasonable period of time. The estimated fair market value of the business based on its proven earnings will be strongly affected by applying a factor (a return on investment multiplier/capitalization rate) taking into account the projected risk and certain investment considerations associated with new ownership.

Although the calculation of a multiplier/capitalization rate for a business valuation can be a long, complicated and confusing procedure, and often is determined using various business valuation methods such as investment alternative build-up methods, industry comparisons, or evaluating against established criteria that considers key business operational factors, the capitalization rate/multiplier calculation method applied on your behalf combines the pertinent elements of most published capitalization rate estimation processes and automatically calculates a multiplier rate based on an assessment of the risk factors in the business being valued. With your input (we will be sending you a Risk Factor Assessment letter shortly), we will arrive at a “score” based upon the assessment of risk for your business. This “score” and resulting valuation is prepared solely on your behalf to guide you in determining what your business might be worth and assist you in determining an appropriate list price. A higher score (based upon a lower determination of risk associated with a particular business) can yield a much higher multiplier than what might be average for the industry in which your business operates. Generally, most profitable businesses with a good history and positive outlook will score a calculated multiplier in the 2.0 to 4.0 range.

Below is a listing of the risk factors which we will consider in determining the appropriate multiplier for your business:
- Continuation of Earnings Assessment
- Business History Assessment
- Business Growth Projection
- Competition Analysis
- Business Expansion Opportunities
- Barriers to Entry for New Competition
- Customer Base Sensitivity
- Management/Key-Employee Retention Projection
- Business Location Continuation
- Operational Facility/Equipment Suitability
- Business Purchase Financing Availability
- Industry Strength Assessment
- Environmental Risk Assessment
- New Owner Social Desirability
- Alternative Investment Returns

Finally, it should be noted that the approach used here is not as rigorous as a professionally developed business appraisal by an accredited professional which may cost thousands of dollars. Thus, where we combine two business valuation methods, a professionally developed valuation may use several approaches and compare/consolidate the results. Also, our approach is intended for use with financially motivated (investment oriented) or strategic buyers and sellers who comprise the vast majority of potential buyers and sellers of a business.