Introduction
Selling your business is a significant decision, and understanding its value is crucial. Business valuation is a complex process that involves various methodologies. In this whitepaper, Houlihan explores three (3) approaches to business valuation: the Market Approach, Income Approach, and Asset Approach. We also discuss earnings adjustments, which are essential for accurately determining the value of your business.
Market Approach
The Market Approach relies on comparable company and transaction data. It involves two (2) common methods:
1. Guideline Public Company (GPC) Method:
- This method involves identifying and selecting public companies with financial and operating characteristics similar to the business being valued.
- Once a publicly traded peer group is identified, valuation multiples such as price-to-earnings or Enterprise Value (EV)-to-EBITDA are derived using publicly traded data (e.g., stock price, enterprise value, net sales, EBITDA, etc.).
- These multiples, often adjusted for comparability, are then applied to the financial metrics of the subject company to estimate fair market value (FMV). Fair market value is often synonymous with total enterprise value and purchase price in a private transaction. This value can then be used to determine FMV of the company’s equity.
2. Comparable Transactions Method:
- This method involves determining valuation multiples from sales of enterprises with financial and operating characteristics similar to the enterprise being valued.
- Once adjusted for comparability, practitioners then apply these multiples to the financial metrics of the subject company to estimate the value of the subject company’s equity or invested capital.
Important Considerations for Market Approach:
- Common Valuation Multiples: EV/EBITDA, EV/EBIT, EV/Revenue, and industry-specific multiples such as annual or monthly recurring revenue.
- Comparability Adjustments: Differences in size, risk, or outlook of the subject company when compared to the companies identified in either method might indicate the need for adjustments to the identified valuation multiples.
- Discounts for Marketability and/or Control: Depending on the method used as well as the subject interest being valued, discounts for lack of marketability (DLOM) or discounts for lack of control (DLOC) may be applied in order to conclude on a marketable/non-marketable or controlling/non-controlling interest.
Income Approach
The Income Approach to business valuation considers historical and/or projected cash flows. There are two (2) main methods:
1. Capitalization of Earnings:
- This method is suitable when a representative level of the expected earnings of a business can be estimated and this level of earnings is expected to increase at a constant rate in the future.
- To compensate the investor for the level of risk associated with receiving the expected earnings, the investor expects to receive a rate of return that measures the risk associated with investing in the ownership interest in the business. A capitalization rate measures the rate of return that the investor would expect to receive less the long-term growth rate in the earnings.
- The subject company’s representative level of cash flows, often estimated as its adjusted EBITDA, is then divided (capitalized) by the rate determined above, resulting in an estimated Enterprise Value of the business. Net debt (cash balance less any interest-bearing debt) is then added to determine the indicated value of the subject company’s equity.
2. Discounted Future Cash Flows (DCF):
- This method is suitable for new businesses, businesses experiencing significant growth or mature businesses. It calculates the present value of the company’s projected future cash flows.
- The first step in a DCF analysis is to estimate annual free cash flows. This involves using historical data, management insights, and trend analysis to create projections. These projections should cover a period that reflects the main growth phase of the company, asset, or security, until it reaches a stable growth and profitability level.
- The second step in a DCF analysis is to discount the projected annual enterprise net cash flows to their present value as of the Date of Value using an appropriate discount rate. The discount rate applied should consider the time value of money, inflation, and the risk inherent in ownership of the business, asset, or security interest being valued.
While the Income Approach is heavily reliant on the quality of inputs and assumptions, it can provide a helpful benchmark for intrinsic valuation.
Cost Approach
Also known as the Net Asset Approach, this approach estimates fair market value based upon the capital necessary to create an equivalent asset. There are two (2) primary methods under this approach:
1. Fair Market Value:
- This method estimates the value of a business or asset based on the price it would command in an open market, reflecting a typical transaction under normal conditions without any compulsion to buy or sell. The analysis is based on the principle of substitution, assuming that a prudent investor would pay no more for an asset than the amount for which the asset or property could be reproduced or replaced, less depreciation from physical deterioration and functional and economic obsolescence, if present and measurable.
2. Liquidation Value:
- This method estimates the value of a business or asset based on the net cash that could be obtained if all assets were sold and liabilities settled quickly, often under distressed conditions, reflecting a rapid sale scenario.
This approach is typically only considered appropriate for highly capital-intensive businesses, real estate holding companies, or other types of holding companies, where the value of the entity is derived primarily from the underlying assets held by the entity and not from additional value added from labor or profitable use of the assets owned.
Earnings Adjustments
Earnings adjustments are made to remove the impact associated with certain income or expense items. Most often, adjustments can be grouped into three (3) general categories:
1. Extraordinary or Nonrecurring Income and Expenses:
- This includes one-time events such as professional fees, litigation, the sale of equipment, and fees associated with the implementation of new business systems.
2. Owners’ Discretionary Expenses:
- This includes owner’s compensation that is different from fair market value, including compensation for family members, club memberships, company vehicles, life insurance policies, and other owner benefits.
3. Nonoperating Income and Expenses:
- These include adjustments related to income or expense items that are independent from the company’s core operations, such as gains or losses from investments, foreign exchange, or asset write-downs.
Conclusion
Understanding the value of your business is essential, especially when considering a sale. A more precise valuation typically employs one or a combination of the Market, Income, and Asset approaches, along with refinements such as earnings adjustments. This also assists business owners and advisors in maximizing valuation for business purposes. Whether your business is well-established or experiencing rapid growth, a comprehensive understanding of these valuation methods will enable you to make informed decisions about its future.
At Houlihan Capital, we understand that selling a business is one of the most significant decisions an owner can make. Our team of experienced professionals is dedicated to providing personalized guidance throughout every step of the sale process. We start by helping you understand the true value of your business through a comprehensive valuation, using industry-standard methods such as the Market, Income, and Asset Approaches. With a clear picture of your business’s worth, we work with you to craft a tailored strategy that aligns with your goals, whether it's maximizing sale price, ensuring a smooth transition, or finding the right buyer. Our commitment is to provide expert advice, seamless execution, and peace of mind as you navigate the complexities of selling your business.
