Most business appraisers agree that business valuation is a unique combination of art and science. Because there is no universal formula that can generate the exact value of a company, deriving the accurate worth of any business requires the consideration of many factors. Such factors include the earnings ability of the business and the risks of the business, among others.
Earnings
Earnings represent the benefits stream (owner’s cash flow) to the owner of the business. Ultimately, the value of a business is determined by what someone would pay for it in the marketplace. Buyers look to purchase a future income stream that will provide a desired return on his or her investment, which will justify the purchase price. As a result, most appraisers base their valuations upon historical and future earning patterns of an operating business. This means that the easier it is for a potential buyer or other individual or entity (such as the IRS) to see the true earnings of the company, the more reliable those earnings will be – which increases the value of the business. To make earnings more transparent, business owners should reduce the amount of “owner perquisites” in their business. These are items that are being expensed by the business, but are a benefit to the owner and are not related or necessary to operating the business itself.
Risk Factors
Every company has unique risks associated with its operation, and appraisers must weigh the company's future opportunities against the perceived business and economic risks. Elements of the business that increase risk will decrease the company’s value. By the same token, elements that decrease risk will increase the company’s value. Some risk factors that influence value include:
Dependence on Key Employees - One of the biggest risks in privately held businesses is dependence on one or two key employees, including the owner. By reducing the reliance on these key employees, the value of the business will be increased.
Diversification - By diversifying the company's customers, suppliers, product lines and employee talent, a company reduces its risk.
Infrastructure - A solid infrastructure of people and systems within a company helps decrease risk, thereby increasing a company’s value. Talented managers, trained employees and established operational systems help the company run smoothly, allowing a more seamless transfer to a buyer.
Timing - The value of a business depends on the timing of internal and external factors. Internally, a company has less risk if it displays a positive trend of historical financial performance. A positive earnings projection also decreases the company's risk. External factors, such as industry stability, market conditions and economic outlooks, all shape the company's future performance expectations.
Assets - In an asset-intensive business, the conditions and efficiency of equipment affect the value of the company. Well-maintained equipment allows buyers to avoid replacement and repair costs. Likewise, the amount, and ability to protect, intellectual property or proprietary content will increase a company's value.
Appearances - The way a company looks, both physically and on paper, affects the perception of value and risk to a buyer. The organization and efficiency of the working environment reflects upon the company and its overall management. Clean, organized financial statements will increase the confidence a buyer has in a company’s actual performance.
