A Guide to the Three Business Valuation Approaches

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If you own a business and you are looking to sell it, to gain investors, or to take out a loan, you probably are well aware of how important the valuation of your business is. The amount of capital you are able to raise in exchange for as little equity as possible is incredibly important while gathering investors. The price tag you get while selling your business is obviously based on the valuation it gets. When you take out a loan to grow your business, the value of the business is used to determine how much of a loan you can get. When you are liquidating a business, the valuation you get determines how much you’re able to repay to your debtors.

With so many different purposes for business valuations, it is no surprise that there is more than one approach that will give you a different, yet entirely accurate valuation. For instance, if the purpose of your business valuation analysis is to liquidate your business, the valuation is based on the value of the assets you have in comparison to the amount of your debts. On the other hand, if you are attempting to gather investors, the earning power of your business matters more than your asset to debt ratio. Here are three of the most common business appraisal valuation approaches:

Valuation Income Approach

The valuation income approach is used to determine the earning power of a business when you are selling it, or gathering investors. While calculating the valuation income approach, cash flow and income are considered, to estimate how much money the business will earn in the future.

For example, let’s say you have a lollipop business out of your home. You might have very little equipment and therefor your asset value might be very low. However, if your business has earned a million dollars in the last 12 months and perhaps you’re going to be releasing a new lollipop product that could be a catalyst in your earning potential, using the valuation income approach will give you a business valuation that includes an estimation of what your business is capable of earning in the future. You probably noticed the word “estimation.” Since no one is capable of seeing the future, there is an element of risk with the valuation income approach. However, the valuation income approach does calculate the degree of risk and factors that into the final number.

Valuation Market Approach

As the name suggests, the valuation market approach uses the value of other, similar businesses to determine the value. Let’s say that your lollipop business is too new to have enough history to determine the valuation income approach. By calculating the value of other lollipop businesses in your area, you can determine the earning potential your business has, and a value of it.

The valuation market approach
is ideal when there are enough other similar businesses to indicate the earning potential in the industry. Some entrepreneurs develop businesses that the world has never seen before; in this case, the valuation market approach does not work.

Valuation Asset Approach

The valuation asset approach is used when a business is being liquidated. Since the business will no longer operate, it does not matter what its cash flow is, or what other businesses in the industry are capable of. The valuation asset approach looks at the net value of the assets less the debts. It sounds straight forward, but the market value assets that have been used by a business requires some conjecture.

A lollipop business might have purchased a lollipop wrapping machine in 1970 that was worth X amount of dollars at the time. The wear and tear on the machine, in addition to the modern value with inflation would have an impact on the market value of the asset now. The most important factor in determining the value of an asset is the dollar value that it could actually collect if sold today. Figuring this out is the greatest science while calculating the valuation asset approach.

Have you ever gotten a business valuation? What approach (or combination of approaches) were used in your valuation calculation? Please share your experience in the comment section below.

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