Three Business Valuation Approaches

Valuation small business

There are a lot of reasons you’d need a good business valuation tool. Maybe you inherited a business and need to determine its value to pay taxes. Maybe you’re getting a divorce and need to determine the value of your business to divide your assets evenly. Maybe you’re going out of business and your assets will be used to settle your debts.

Each of these examples require a valuation that is basically a different view of the same business, and require a different business valuation method. In fact, the reason you need your business valuation tool dictates the method that the small business valuation tool should use to determine what your business is worth, and the method that is used to determine your business valuation appraisal creates a starkly different final appraisal value than any other method. Confused? We thought so. Here is an overview of the business valuation methods:

Three Business Valuation Approaches

  1. Asset-based Business Valuation

    Let’s say that you’re liquidating your business and leaving the game. You’re done and you’re ready for retirement. You have a certain amount of debts, and you have some assets to use to pay off those debts. Maybe you’re going bankrupt and already know that your assets won’t completely fulfill the debts that you owe. The asset-based approach would help you determine how much you’ll be able to repay to your debtors after all of your assets are liquidated. Or how much money you’ll have in the bank after your debtors are repayed, if you’re in the green.

    This approach involves determining the market value of your assets compared to the value of your debts. The key word here is “market value.” This calculation requires a certain amount of estimation. The amount that you paid for it up front doesn’t represent what the asset is worth now, and the depreciated value of the asset might not be accurate either, as market fluctuation could change the “going rate” of your asset, regardless of amount of life you have left in it. This is why getting an accurate asset-based business valuation relies on having a robust business valuation tool.

  2. Income-based Business Valuation
    Now let’s say you are trying to sell your business to someone else who will continue to operate it. Sure, your debts and assets are a factor in the sale, but the real reason that anyone would be interested in purchasing your functioning business is because of its ability to generate income. The income-based approach reviews income statements over the previous three years (more or less depending on the nature of your business and the sale) and estimates what its earning power is in the future.

    The unknowns in this approach include what part of the income is generated because you specifically own it (maybe you manage to do the job of ten people on your own, paying for ten new employees because you aren’t managing it any more would certainly eat into the income). Another wild card that your income history doesn’t show is what the future of your market will look like. Maybe your product is somewhat of a one-hit-wonder, and once its 15 minutes of fame are over, your predecessor will struggle to generate the income on the trajectory that you have achieved. These risk factors are taken into consideration, if you use the right small business valuation resources.

  3. Market-based Business Valuation
    In our last scenario, we will talk about getting a business valuation if you are generating income but don’t have a history to use the income-based approach. Let’s say you have a fairly new business (or a business that has grown a lot in recent times, so your history isn’t representative of your future). Maybe you need a loan in order to fulfill a purchase order that’s much larger than you’ve ever made, in order to make sales much larger than you’ve ever made. In this case, you could create a business valuation based on the financial statements from other similar businesses of your size in your industry. This will show your lenders the earning potential your business could have if they grant you the loan.

    The unknown here are the magic beans that makes another business successful that might not apply to you, or if there are no other similar businesses in your industry.

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