Understanding The Value Of Your Company

May 2016       Download PDF      Print

To maximize the value of your company, you need to develop a plan with clearly defined goals. However, you can’t expect to achieve a goal until you understand where to begin, what kind of challenges you face, and how to monitor your progress along the way.

The first step in building company value is to understand how much your business is currently worth and which factors determine your company’s value. A business valuation, or business appraisal, will provide you with such information. Below we answer some commonly asked questions about business valuations.

When are business valuations needed?

A common misconception is that you only need a business valuation to satisfy a legal and/or tax event. In reality, business valuations are needed for a variety of circumstances, including:

  • Selling a business or acquiring a business
  • Drafting a buy/sell agreement with a business partner
  • Obtaining an SBA loan to finance growth
  • Implementing an Employee Stock Ownership Plan (ESOP)
  • Divorcing a spouse when the marital estate includes a business
  • Gifting or donating closely held stock
  • Converting a company from a C corporation to an S corporation

What information is used to value a company?

To perform an accurate valuation, business appraisers need the subject company’s financial statements and tax returns for the previous four to five years, interim statements for the current year, and copies of any forecasts or projections. Other items commonly requested include documents that describe the company’s services and/or products, asset and inventory lists, details of liabilities, and reports completed by other professionals or consultants. Appraisers also use various sources to gather pertinent industry, economic, and M&A market data.

How do business appraisers determine value?

There are three fundamental approaches to valuing a business: the income approach, market approach, and asset (or cost) approach. Appraisers select an approach (or a combination of approaches) by evaluating the relative strengths and weaknesses of each and identifying which are most appropriate considering the purpose of the valuation and the type of company being valued.

Income Approach

Under the income approach, appraisers determine the value of a company based on its anticipated future earnings. Appraisers may use one of two methods: the Multiple Period Discount Method (MPDM) or the Single Period Capitalization Method (SPCM). The MPDM is typically applied to growing companies, or to companies whose earnings are expected to change significantly from year to year. The SPCM is typically applied when a company has stable earnings.

Market Approach

In this approach, the appraiser determines a company’s value based on the selling price of similar businesses. The market approach assumes that the price paid for a business in a transaction is close to its fair market value and that value comparisons can be made if there have been enough transactions involving similar businesses. Appraisers search for similar companies based on certain criteria, such as industry, geographic location, revenue, number of employees, and financial performance ratios.

Asset Approach

This approach focuses on the fair market value of a company’s total assets minus its total liabilities. Appraisers often apply this approach when a company is asset-intensive or if it is under-performing.

What other factors influence the value of my company?

The value of your company is influenced by many different forces, both internal and external. In addition to the factors examined under the traditional business valuation approaches, appraisers also consider:

  • Economic and political environment (i.e., interest, tax, and unemployment rates)
  • Industry lifecycle (i.e., growing, maturing, declining)
  • Market position and competitive landscape
  • Goodwill and other intangible assets
  • Strength of customer relationships
  • Diversity of customer base, suppliers, products, and services
  • Skills and quality of managers and key employees
  • How dependent a company is on its owner
  • Pending litigation or disputes

Start building value with a business valuation

While certain events may require the need for a business valuation, having one performed is also essential for long-term planning. A business appraisal can be a valuable strategic planning tool that can help you determine how your firm is performing compared to its peers, what areas of your company drive value, and how to increase that value. Owners often obtain annual updates to measure growth and monitor the effectiveness of their growth initiatives.

To obtain a business valuation, find an appraiser with the training and expertise needed to provide accurate and defensible business valuation reports. You can learn more about the credentials of business appraisers in our publication, The ABCs Of Business Valuation Designations.