Business Valuation by Brokers

Key Takeaways

• Valuation is based on more than profit.
• Multiple methods are applied for balance.
• Industry benchmarks guide realistic pricing.
• Goodwill and intangible assets matter.
• Accurate valuations attract serious buyers.

The Importance of Business Valuation

Before diving into the methods, let’s first talk about why business valuation matters. For us as business brokers, determining the value of a business is crucial for setting a fair asking price, structuring deals, and negotiating terms. A proper valuation helps both buyers and sellers make informed decisions and avoid costly mistakes. When we value a business, we consider various factors, including its financial health, market conditions, industry trends, and future earning potential.

Methods Used to Evaluate Business Worth

1. The Income Approach

The income approach is one of the most commonly used methods to determine a business’s worth. This method focuses on the future income a business is expected to generate. Business broker  often use this approach when the business has a consistent track record of earnings or when it’s in an industry where future profits are predictable.

The core principle of the income approach is the idea that a business’s value is equal to the present value of its future cash flows. These future cash flows are typically adjusted for risk factors, industry stability, and other relevant factors. We usually calculate the projected earnings before interest, taxes, depreciation, and amortisation (EBITDA) or the net income of the business and apply a capitalisation rate to determine the present value.

In practice, we might use two sub-methods:

• Discounted Cash Flow (DCF): This involves estimating the future cash flows of a business and then discounting them to the present using a required rate of return or discount rate. The DCF method accounts for the time value of money, essentially acknowledging that money today is worth more than the same amount in the future.
• Capitalisation of Earnings: In this simpler version of the income approach, we calculate the business’s expected annual earnings and apply a capitalisation rate to estimate its value. The capitalisation rate typically reflects the risk involved and the return an investor expects.

The income approach is especially useful when dealing with businesses that are expected to generate steady cash flow over the long term, such as service-based or subscription businesses.

2. The Market Approach

The market approach is based on the idea that the value of a business can be determined by comparing it to similar businesses that have recently been sold in the market. This approach is often used when there is a sufficient number of comparable businesses available for comparison. We typically use this method when the business operates in an established market with lots of transaction data.

To conduct a market approach valuation, we gather data on recent sales of businesses in the same industry or sector. We then apply certain multiples, such as price-to-earnings (P/E) ratios, price-to-revenue ratios, or price-to-EBITDA ratios, to estimate the value of the business in question.

The key to using the market approach effectively is finding truly comparable businesses. We look for businesses that are similar in size, market presence, financial performance, and growth potential. The more comparable the businesses are, the more accurate our valuation will be.

3. The Asset-Based Approach

The asset-based approach focuses on the value of a business’s assets and liabilities. This method is particularly useful for businesses that have substantial tangible assets, such as property like real estate, or personal, machinery, or inventory. In many cases, we use the asset-based approach for companies in liquidation or when the business is struggling to generate strong earnings.

To use this approach, we first calculate the total value of the business’s assets. These assets can include physical assets like property, equipment, and inventory, as well as intangible assets such as patents, trademarks, or intellectual property. Then, we subtract the total liabilities to arrive at the net asset value of the business.

The asset-based approach can be helpful when assessing businesses in industries that rely heavily on physical assets, such as manufacturing, construction, or real estate. However, it’s important to note that this method does not consider the business’s future earning potential, which is why it’s often not suitable for businesses with limited assets but high growth potential.

4. The Rule of Thumb Method

The rule of thumb method is a simpler and more generalised way of estimating a business’s value. This method involves applying a predetermined industry multiple or formula to the business’s earnings or revenue. The multiple used can vary depending on the industry, but it’s usually derived from industry standards or historical data.

For example, we might find that businesses in a particular sector typically sell for three times their EBITDA. While this method is easy to use and provides a quick estimate, it’s not always as accurate as the other approaches, as it doesn’t account for specific business circumstances or nuances. It’s more of a rough estimate and should be used as a starting point for further analysis.

5. The Comparable Transactions Method

The comparable transactions method is similar to the market approach, but instead of looking at the current market, we look at historical transactions involving similar businesses. This method involves reviewing the sale prices of similar businesses in the past to determine the value of the business in question.

We’ll examine factors like the sales price, earnings, and growth potential of businesses in the same sector to establish a fair market value. The comparable transactions method is highly effective when the industry has enough transaction data to draw meaningful conclusions.

Conclusion

A proper business valuation is more than numbers, it’s clarity. If you’re thinking of selling, planning an exit, or just curious, we’re here to guide you with experience and precision. Get in touch with Sunset Business Brokers today to book a confidential valuation consultation.

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