Perhaps the most frequent question I hear from business owners is, "What do you think my business is worth?". My answer usually is, "Well, that it depends on who is looking at it and for what reasons." For instance, lenders pay attention to liquidation value. Investors are interested in capitalized earnings value, and potential buyers look to the value of like companies. Insurance companies are interested in replacement value, and … your spouse’s divorce lawyer will assume your business is the next IBM.

The word "value" coveys multiple meanings to different audiences, and almost as many methods for valuing a company exist as there are reasons to do so. However, most valuation methods fall into three categories: (1) valuations of underlying assets focused on the balance sheet; (2) valuations based on earnings and cash flows using the income statement and; (3) valuations based on comparisons of performance and acquisition activity for similar companies. Regardless of the method employed, in the final analysis the true value of a company can be established only in the marketplace --- the real value is what a buyer is willing to pay.

As I discuss the valuation methods that follow, keep in mind two important points. First, over the years both general and industry-specific "Rules of Thumb" have been developed. However, I would add a caution that, despite being easily understood, they can be very misleading. Second, it is important to understand that value has two dimensions; price and terms. In the methods outlined below it is understood that the value determined would be for a cash transaction today and does not take into account the time value of money, low market interest rates, contingent payouts, asset vs. a stock purchase, debt assumption, etc. All of these are important considerations in determining the value of a company.

Asset Valuations

Valuations analyzing assets do not consider future earnings potential and, therefore, are not particularly appropriate for forming valuations in conjunction with a going concern.

Book Value: Frequently referred to as "net worth" on the balance sheet, book value is the difference between total assets, net of depreciation, amortization and total liabilities. In relatively new companies and turnaround situations, net worth may more closely equate to the company’s economic value. As a general rule of thumb, companies in multiple industries are valued around one and one-half to two times book value.

Appraised Value: An appraisal will result in an economic balance sheet reflecting both tangible and intangible assets recorded at their "fair market value". If a company has experienced stagnant performance or has heavy fixed assets, the appraised value may represent its best economic worth.

Liquidation Value: Liquidation value is a company’s worth if its assets are sold for cash, its outstanding debts are paid, and the expenses associated with shutting down the business (commissions, taxes, legal accounting, etc.) are satisfied. Liquidation value is relevant for a distressed company, where it can serve as a starting point with existing creditors, lenders, and investors.

Replacement and Start-up Value: Replacement value builds on the market valuation of tangible assets. Crediting financial value for developments efforts and accumulated technical know-how. This method can be particularly important for very new companies with high development costs and limited sales history, or to establish companies where significant resources have been committed to reengineering products or building distribution channels which have not yet been reflected in current revenue profitability. A common rule of thumb for value credit is $100,000 per person-year of R&D expenditures. Up to another $100,000 per person-year may be credited for lost selling, overhead costs and time to duplicate a company’s products.

Valuations Based on Earnings/Cash Flows

Valuations based on earnings or cash flows as their basis are more appropriate means for valuing a going concern. One method capitalizes past earnings, while another discounts future returns. Most financial advisors use a weighted average of these methods to determine value.

Discounted Cash Flow: The discounted cash flow (DCF) approach is often applied to high-risk situations such as start-ups and turnarounds in order to define the "present value" of all future benefits. Its value is determined by the combination of current assets and future financial performance. DCF requires a forecast of cash flow (usually five years) that can be achieved reasonably. The present value of the cash flow is determined by discounting it for the time value of money. The appropriate discount factor can range from an average cost of
funds for traditional businesses to a high percentage for high-risk start-ups and turnaround situations.

Free Cash Flow: Free cash flow is defined as earnings before interest, taxes, depreciation and amortization (EBITDA). Free cash flow represents funds available to meet debt and equity payments. Utilizing this valuation method, EBITDA is multiplied by a value multiplier – usually somewhere between three to eight times depending upon the company’s sales growth, industry, earnings, exit options, etc. Five times free cash flow is a reasonable starting point for a healthy company, which equates to a 20% capitalization rate.

Market Valuations

Market-based valuation methods value a company based on comparable transactions. These methods are considered reliable ince at least two parties have put a value on a particular going concern after negotiating long and hard, attacking each others’ values, and finally settling on a price and terms. Valuation methods usually include a price earnings ratio, a comparison of comparable companies, and a sales multiple.

Price Earnings Ratio: The price to earnings ratio (P-E) is determined by a multiplier as is applied to the current net profit after tax earnings of the company. The multiplier is determined by examining the public ratios for publicly traded companies in a comparable business. In general, higher P-Es will reflect growth prospects, while lower P-Es will reflect low growth and/or perceived financial risk. Public company multiples will be higher than private valuations due to illiquidity discounts. This discount can be as much as 20% to 40%, but can be partially offset by a control premium which may be paid to majority shareholders.

Comparable Companies: An analysis of merger and acquisition transactions during the past two to three years for companies that provide similar products or services is another good approach to establishing value. It is difficult to obtain accurate information on private company transactions and determine similar product line performance. As a result, using only public market companies with generally greater sales revenues earnings and product line offerings will usually generate an inflated valuation. Therefore, the 20% to 40% illiquidity discounts and the control premiums mentioned above are applicable.

Sales Multiple: Sales multiples historically have been one of the most widely quoted valuation methods. It is important to understand a specific company’s industry multiple since the multiples for different industries vary widely. The company’s growth prospects and the excitement of its shareholders play major roles in this valuation method. As a rule of thumb to establish the appropriate sales multiplier, double the gross margin percentage of sales (i.e. if the company’s gross margin is 60% the sales multiplier is twice or 1.2 times sales revenues). This method obviously favors higher margin businesses, and it is important to consider the sales period being used. Most agree that the last twelve months of actual performance is the most appropriate.

Determining the value of a business is as much an art as it is science. It is scientific in that specific methods are generally applied and have gained acceptance by the business accounting and legal communities. However, it is an art that requires knowledge, experience and judgement regarding markets, competitors, macro economic forecasts, markets/liquidation values for tangible assets, and the subjective qualitative elements of valuing intangible assets like management skills, patents, trademarks, licenses, proprietary technology, sales contracts and the company’s distribution network.

It is possible to determine within reasonable limits the financial worth of a company. A number of methods have been presented for valuing a company, but not all methods need to be applied. The use of a given method depends on the nature and circumstances of the individual company, and every valuation depends on the expert
judgement of the person doing the analysis who should be prepared to defend their assumptions and methodologies if called to account.

There can be many reasons for valuing a business and those reasons may determine the methods of valuation which, in turn, can effect significantly the value assigned to the business, making it clear that value is in the eyes of the beholder.