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How to Value a Company: Understanding Our Company Valuation Methods

3/30/2021
By
CPA/ABV/CFF, CVA, MAFF, CITP, MCP
Portrait of Richard L. Craig

The success of buying or selling a company can hinge on the correct valuation. This is why it is so important to work with a firm that knows how to value a company.

At 415 Group, our valuations are calculated via three main approaches: asset, income, and market. There are many methods under each approach.

Asset-Based Approach

When using this methodology, we take a look at all of the assets—including tangible items like building, equipment, and inventory, as well as intangibles such as goodwill, trademarks, and patents—to calculate the value of the company. This is very common with businesses that don’t have recurring, predictable revenue, such as contractors, or asset-heavy accounts, such as real estate holding companies. 

During the COVID-19 pandemic, we’ve been using asset-based approaches even more. Many companies like restaurants and hotels are generating negative cash flow and experiencing losses. Since we can’t base the value of their company on their future positive cash flow streams, we take a look at their assets instead to formulate a fair value.

The asset-based approach can give us any business’s base-level valuation. In most cases, they can’t be worth less the net value of their assets.

Income Approach

The income approach—also called the “earning approach”—is what most businesses are bought and sold under. This method compares the future income the buyer will receive from the company to their risk on investment. To get the valuation, we divide the income by the risk. It sounds straightforward, but there are two primary methods to get there. The first is the discounted cash flow methodology, and the second is the capitalization of income.

The discounted cash flow (DCF) methodology looks at expected future cash flows. We base the valuation on the projected income of the company. Plotting out the future works well for publicly traded companies or more sophisticated ones that have the ability to do long-term projections that are reliable. It can also be used for start-up companies that don’t have a history of cash flow yet or ones that are going through changes or expansions for the upcoming few years.

On the other hand, capitalization of income looks at the past in order to predict the future cash flow. This method is used more for small businesses that are stable and have recurring, somewhat predictable, income streams. We look at the past business cycle of their industry and discuss whether or not we can project that history on to the future. We make adjustments as needed, and then determine the value of the company.

Market Approach

When using the market value approach, we compare the business you are buying or selling to similar businesses that have been sold. We comb through our databases to discover relevant businesses’ sales prices. Then, we divide that transaction by variables—or multiples—in your company to determine what the value of your business would be.

This method is similar to how you would approach buying a house. You would compare the house you want to buy to one that sold down the block. If the neighbor’s house sold for $100,000, you would also have to factor in its multiples. Was the selling price influenced by the number of rooms, square footage, acreage, or something else? Once you figure out the multiple that makes the most sense to compare it to, you can get a better valuation of the house you’re looking to buy.

There are two potential pitfalls when finding the market value of a company. The first is that many people get excited about what a company sold for and assume they can buy or sell their company at the same price. However, they neglect to factor in the specific multiple. If a friend of a friend sold their business for seven times the cashflow, you might feel yours is worth that too. Did that multiple include cash, inventory and debt? Was it a stock sale or an asset sale? Was it an adjusted or historic cash flow multiple? Even the type of business or industry can greatly impact the multiple selected. Without getting a realistic valuation, you’re setting yourself up for disappointment to apply a rumored multiple to your business.

The other pitfall is synergistic value. This usually increases the valuation. That’s because a “hypothetical buyer” is not likely to buy your business on a whim. Instead, it will be someone who is already in the industry, such as a competitor, key employee, vendor, or customer. These types of buyers have the ability to potentially make more cash flow from your business than you do because of the synergies they bring to the table. If you’re selling a business, this isn’t necessarily bad; but if you’re looking to buy a business, keep this in mind.

How to Value a Company Successfully

Before we even begin the valuation process, we figure out the standard of value for your specific purpose of buying or selling. This standard helps us decide which valuation method to use, since it’s dangerous to use one valuation for multiple purposes. Here are some examples of different standards: 

Once we agree to a standard, 415 Group moves forward with the valuation process. It’s important for business owners to be very open to discussions about their company, assets, cashflow, and everything else that goes into building a valuation. If there are items a business owner doesn’t want to discuss, it will hinder the process.

When we run into this roadblock, it’s usually related to a small business’s efforts to minimize taxes. This could be from an owner deducting things like a spouse’s vehicle, vacations, and their home office. Or, it could be an owner who pockets a lot of cash from their business without reporting it. In both instances, this lessens their multiple of cashflow, bringing down the value of their business. Disclosing items to a potential buyer that don’t show up on the tax returns make it much more difficult to get the maximum value for your business when you are ready to sell. Being upfront with your advisor will help you in the end.

Speaking of advisors, make sure you work with a trusted one. Do not try to calculate the valuation of a company on your own or by using an online valuation calculator. Using an independent valuator will prevent you from heartache later on. A firm like 415 Group, that has performed valuations for decades, will be able to work through very technical valuation methods, know how to properly manipulate multiples, and have the specialized databases to find comparable companies. They also have the experience of working hands-on with thousands of businesses a year as tax preparers and business advisors, so they have intimate knowledge of local industries, which can apply to your valuation.

When people try to do a valuation on their own, the sales usually don’t go through. It’s important to get an unbiased opinion before you start dreaming about the millions you’re going to make on the sale.

Interested in selling or buying a business? Want to know more about how to value a company? Contact our trusted advisors at 415 Group today.

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