Probably the most popular question I get from business owners is “how much is my business worth”? Similarly, business buyers, especially those entering the market for the first time, are curious as to the valuation “formula” in general or on a specific business they are considering purchasing.

My usual response is “what is the purpose of the valuation?” There are several reasons why one might want to have a business valuation done, and the purpose helps define which person and which valuation product is used.

As a licensed Business Broker I can give my expert opinion, or Broker Opinion of Value (BOV), on the fair market value (FMV) of a business – assuming that the business is going to be sold on the open market. The BOV is typically a good valuation product for main street businesses, i.e. those with enterprise values up to $2 million.

For larger businesses (low mid-market) or if the purpose of the valuation is for obtaining a line of credit, buy/sell agreement, or any of the other reasons listed on the previous chart, then it is advisable to engage the services of a certified Business Appraiser. At Murphy, we have both pieces covered. As a Broker I can utilize the BOV tool that Murphy developed to organize and streamline the process of performing a BOV. Additionally, we also have several certified appraisers at our corporate office that can prepare a business valuation product that fits the purpose.

As the above graphic demonstrates, there are four types of valuation products offered by Murphy. Beyond the BOV, the appraiser will perform a Calculation of Value (COV) Report, a Business Valuation Report (BVR), or a Business Appraisal Report (BAR). The content and consequently the time spent on each report increase with each product, and an assumed level of confidence as well. In those valuation situations driven by possible or current litigation then it is always the BAR that is performed which provides the most comprehensive package of information to the reader. Not surprisingly, the price of each valuation products rises as the level of effort and amount of content increases through each product level.

There are three standard approaches to valuation theory – namely the Market Approach, the Income Approach, and the Asset Approach. An appraiser may wind up using one or more of these in combination when determining the value of the business. The BOV utilizes the Market Approach but also incorporates two additional approaches that factor in a more qualitative analysis and a hypothetical Buyer’s Test Method that gives the perspective from an investor point of view (not an owner/operator).

The Market Approach uses “multiples” observed in the sale of similar assets in the market, somewhat similar to the approach your realtor uses when finding “comps” that are similar to your house. In terms of businesses, the Broker or Appraiser typically has access to databases of shared closing data such as BIZCOMPS or PeerComps where a statistically significant number of comparable businesses sold can be analyzed. Multiples of Price/Revenue and Price/SDE (Seller’s Discretionary Earnings) and in mid-market companies Price/EBITDA are established and other key factors related to the business being valued are analyzed to determine the FMV. Multiples vary based on industry, revenue, location, etc. so it is important to query/extract the proper data to give a more accurate result.

The Income Approach has two basic methods: the Single Period Capitalization Method which is typically used when the business’s net cash flow/earnings growth is stable (constant nominal growth rate); and the Multiple Period Discounting Method which is used when the business’s net cash flow/earnings are expected to vary significantly with time. In layman’s terms, the Income Approach looks at future projected earnings and uses a discounted cash flow model to determine the FMV. In order to work properly the future projections must be well developed and not just pie in the sky assumptions.

The Asset Approach uses an Adjusted Book Value Method when valuing a going concern, i.e., the business will continue operating into the future. This method takes the fair market/replacement value of assets minus liabilities, and also includes the Intangibles (good will, intellectual property, etc.) If the business will not continue operating into the future then the valuation is based on the Liquidation Value.

There are a lot of valuation “rules of thumb” out there that unfortunately cloud and confuse owners and future owners of businesses (“I heard Google just bought company ABC at 20 times revenue so I should get something similar to that for mine!”). As important and often life-changing as the purchase or sale of a business can be, it is prudent to hire a professional who understands the current market and has access to data and trusted formulas/processes that in the end provide a high level of confidence in the value of the business so in turn the proper decisions can be made.

Learn more about business valuations at http://www.murphyvaluations.com/.