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A Glossary of Typical Valuation Methods

Posted by sb_admin on August 11, 2010
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The field of business valuation can appear complex and complicated – with its many different methods of arriving at the worth of a company.  If you’re a business owner interested in buying or selling a business, this little list might come in handy whenever other owners and brokers start throwing around this foreign terminology.

Adjusted Book Value – The book value of a firm’s balance sheet after the value of assets and liabilities is increased or decreased to reflect their fair market value, also referred to as “modified book value.”  It is one of the least controversial valuation methods.

Asset Valuation – It is the determination of the value of capital assets or fixed assets, the value at which they should be shown in their owner’s balance sheet.  This method is often used for retail and manufacturing businesses because they have a lot of physical assets in inventory.

Capitalization of Income Valuation – This is commonly used by service organizations because it places the greatest value on intangibles, while giving no credit for physical assets. Capitalization is defined as the Return on Investment that is expected.  A list of variables is ranked with a score of 0-5, based on how strong the business is in each of those variables. The scores are averaged for a capitalization rate, which is used as multiplication factor of the discretionary income to arrive at the business’ value.

Capitalized Earning Approach –  Based on the rate of return in earnings that the investor expects. For no risk investments, an investor would expect eight percent.

Cash Flow Method – Based on the amount of money one could receive from a loan, based on the cash flow of the business. The cash flow is adjusted for depreciation, amortization, and equipment replacement, then the loan amount is calculated with normal business loan calculations. The amount of the loan is the value of the business.

“Cost to Create” Approach
– The buyer calculates his or her start up needs in terms of time and money.  Then, they will look at a business and analyze what it offers, and what it lacks, relative to the buyer’s start up plan. The buyer will calculate value based on his or her projected costs to organize personnel, obtain leases, obtain fixed assets, and cost to develop intangibles such as licenses, contracts, copyrights, etc.)

Debt Assumption Method – This usually indicates the highest price. It is based on how much debt a business could have and still operate, using cash flow to pay the debt.

Discounted Cash Flow – Based on the assumption that a dollar received today is worth more than one received in the future. It discounts the business’s projected earnings to adjust for real growth, inflation and risk.

Excess Earning Method – This is much like the Capitalized Earning Approach, however, the return on assets is separated from all other earnings, which are interpreted as the “excess” earnings, generated.  Usually return on assets is estimated from an industry average.

Multiple of Earnings – Here, a multiple of the cash flow of the business is used to calculate its value.  This is one of the most common methods used when valuing a business.

Multiplier or Market Valuation –  This uses an industry average sales figure from recent business sales in comparable businesses, as a multiplier. For example, the industry multiplier for an ad agency might be .75, which is then multiplied by annual gross sales to arrive at the value of the business.

Owner Benefit Valuation – On an income statement, “owner benefit” is represented as the seller’s discretionary cash for a single year. The method that is used to value a company is derived by multiplying this amount by 2.2727.  This formula is best suited for businesses whose value is derived from its ability to generate profits and cash flow.

Rule of Thumb Methods – These are quick and easy methods based on industry averages that help give a mere starting point for the valuation. While not popular with professionals, this is an easy way to get a general figure on what your business might be worth. Many industry organizations provide rule of thumb methods for businesses in their industry.

Tangible Assets Method – The value of the business is based essentially on what the current assets of the business are worth.  This method is often used for businesses that are losing money.

Value of Specific Intangible Assets – This is useful when there are specific intangible assets that come with a business that are highly valuable to the buyer.  For instance, a customer base would be valuable to an insurance or advertising agency.  Here, the value of the business is based on how much it would have cost the buyer to generate this intangible asset by themselves.

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