How to Value a Company: Understanding Our Company Valuation Methods

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.

We’re often asked, “What are the 3 ways to value a company?” At 415 Group, our company valuations are calculated via three main approaches, each including many methods within them:

1. Asset-Based Approach

2. Income Approach

3. Market Approach

1. Asset-Based Approach

When using this method to value a company, 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. This methodology 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 used asset-based approaches even more compared to other company valuation methods. Many companies like restaurants and hotels were generating negative cash flow and experiencing losses. Since we couldn't base the value of their company on their future positive cash flow streams, we took 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, a business can’t be worth less the net value of their assets.

2. 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 and adjusts the history to eliminate non-recurring events. 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. 

3. Market Approach

Market approach is the last of our main company valuation methods. 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 Do You Calculate the Value of a Company Successfully?

Before we even begin the valuation process, we select 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: 

• If you are gifting your business to your children, you will follow the IRS guidelines which often create a much smaller value as they require a hypothetical buyer and seller in their standards and allow substantial discounts.
• If you’re selling your business through the market value approach and a synergistic transaction, the value many times will be much higher.
• Are you buying out a partner? The valuation will be different depending on many factors, such as whether you’re buying 50% or 100% of the company, and including whether discounts for liquidity, marketability, and lack of control (minority) will be taken into account.
• If you’re liquidating a business, we’ll end up using a method that calculates a much lower value than others. 

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.

How to Value a Business Quickly

How do you quickly value a business? This question is somewhat of a catch-22. An opportunity can pop up for business owners who then expect a quick answer for quick results. However, when you work with a trusted advisor, the process may take longer, but you will get a better value in the end.

Do not try to calculate the valuation of a company on your own or by using an online valuation calculator. Using a certified 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 company 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.

The Importance of Business Valuation Accreditation

CPAs who specialize in this line of work have an Accreditation in Business Valuation (ABV) certification. They are awarded this designation after meeting all the qualifications from the American Institute of Certified Public Accountants (AICPA). These CPAs then need to maintain their ABV status through specific work experience and continued education.

At 415 Group, we’re proud to have the largest accredited business valuation team in Stark County. Over the years, we have appraised large and small companies across a wide range of industries. By using proven valuation methodologies, we help you determine your financial position to make the best strategic decisions possible.

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.