This article is the first in a four-part series based on the book A Field Guide to Business Valuation, written by BerryDunn’s Seth Webber and Casey Karlsen.
A banner hanging on the wall of a particular consulting firm states, “In God we trust – everyone else, bring data.” The message of this sign is humorous and clear: if one wants people to agree with one’s position, one must provide supporting data. This is particularly true when making major decisions.
Some of the most important decisions a business owner will make are related to the transition of ownership in their business. Yet when they come to the table for these big decisions, people sometimes neglect to bring the most important thing: data. At a minimum, they need to know the value of their business. It would also be beneficial to understand their business’s value drivers, risk profile, profitability drivers, and performance relative to their peers. A thorough business valuation contains this information and more.
Our favorite illustration of the business valuation process is the “valuation rocket ship.” The economic overview, industry analysis, and company overview provide the base to launch the valuation. The different approaches are then used to create three different perspectives on value. All of this information is then synthesized into the conclusion of value.
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Economy, industry, and subject company analysis
The economic overview sets the groundwork for factors affecting value that are present in the general economy (unemployment rates, inflation, interest rates, etc.). The scope then narrows to the specific industry in which the subject company operates. The industry analysis discusses factors such as historical performance for the industry, supply chain risks, and barriers to entry. Valuation reports then get to the heart of the matter: the subject company. This analysis includes the history, ownership, risks, and other factors that may affect value.
Analysts carefully study the subject company to identify the features that affect value in an actual or hypothetical sale of the business. Acquirers need to know how a company operates and what factors may affect its viability and profitability moving forward. Analysts spend a lot of time looking for items that affect the risk profile of a company. Risk and business value are like children playing on a see-saw: As risk goes up, value goes down.
Once these analyses are complete, the data is considered through different lenses to get a complete picture. Businesses are commonly valued using three common approaches: The market approach, the income approach, and the asset approach, as we’ll discuss below.
Market approach
To understand the market approach, an analogy to the appraisal of real estate may be useful. If one is interested in buying a house, one could look at the price of similar houses to estimate the value of the house in question. Similarly, if one wishes to value a business, one can estimate its worth through a comparison to the sale of similar businesses.
Income approach
If one is trying to estimate the value of an income-producing property such as an industrial warehouse that will be leased out, one could estimate its value based on how much income it will generate over its life. This is called the income approach. Just like with income-producing properties, business value may be estimated based on how much income businesses are expected to generate.
Asset approach
A third way to value a building is by looking at how much it would cost to construct the building rather than buying a completed building. This “make vs. buy” approach is known as the cost approach for real estate appraisals. In the business valuation community, this approach is known as the asset approach. Rather than looking at the value of the company as it exists today, one could estimate value based on how much it would cost to start a similar company.
Conclusion of value
There is a parable about six blindfolded men who encountered an elephant for the first time. They each inspected the elephant by touching it with their hands. The first man felt the elephant’s trunk and concluded that an elephant was a type of large snake. The second man reached the elephant’s ear and stated that an elephant must be a type of fan. The third man felt the elephant’s leg, noting that an elephant is like a tree trunk. The fourth man, feeling the elephant’s side, thought that an elephant was like a wall. The fifth man felt the elephant’s tail and opined that an elephant is a type of rope. The last man felt the elephant’s tusk and decided that an elephant must be like a spear.
As this parable illustrates, when we have a narrow focus and consider only one perspective, we arrive at faulty conclusions. We can make this error in business valuations if we apply only one method to value a company. Each valuation method provides us with a different perspective on value. By considering several different methods, we can get a clear picture of what the subject company is worth.
BerryDunn’s Business Valuation Group partners with clients to bring clarity to the complexities of business valuation while adhering to strict development and reporting standards. We render an independent, objective opinion of your company’s value in a reporting format tailored to meet your needs. We thoroughly analyze the financial and operational performance of your company to understand the story behind the numbers. We assess current and forecasted market conditions as they impact present and future cash flows, which in turn drives value. Learn more about our team and services.