Valuation

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Valuation is the process of putting a price on a piece of property. The value of businesses, personal property, intellectual property (such as patents, trademarks, and copyrights), and real estate are all commonly determined through the practice of valuation. Businesses are valued for many tax, legal, and business reasons but selling the business is the usual motive. Determining the value of a business is simple yet complex. The value is what a knowledgeable buyer is willing to pay for it. And what price should a buyer be willing to pay? Here things become complicated. More than one valuation method exists but each one must take future earnings into account if continued operations are planned.

Theory recognizes three approaches to business valuation: the income-based approach, asset-based approach, and the market approach. The income approach is the most commonly used and is based on an entity's estimated future income stream. The asset-based approach is based on a straight forward determination of the collective value of an entity's assets. The market approach is a hybrid form of the earlier two. Using the market approach usually involves utilizing some market multiple of assets and income.

Putting a value on a small company is much more difficult than establishing the value of a large, publicly traded company. Publicly traded companies have a known value on any given day—the value of their outstanding stock. The value of small companies is much harder to establish, especially family-owned or closely held companies, companies that are unique in the marketplace, or companies built by creative entrepreneurs who will not be running the companies in the future. The valuation of a small company is usually best accomplished by using more than one method and melding the results of various assessments in a way that best reflects the individual business.

APPROACHES TO VALUATION

Of the many methods used in determining the value of a business, some are better suited to certain business types than others. Finance companies tend to value a business at what the assets will bring at a liquidation auction. Investment bankers and venture capitalists, on the other hand, tend to be interested in rapid appreciation and high return on investment and, thus value a business on a discounted future cash flow basis. Statisticians tend to use complex deviation curves based on historical performance to project future earnings when doing a business valuation. Corporate America looks to the prevailing profit-to-earnings (P/E) ratios, unless the market is depressed, in which case they use book value.

Rules of Thumb

Because the cost of having a formal appraisal performed may be prohibitive for small businesses, owners will frequently turn to their accountants for assistance with a business valuation. Accountants faced with this task often revert to what are known as business valuation rules of thumb to try and determine a range of values for their clients.

Rules of thumb are standards established for businesses in the same industry. Brokers and financial intermediaries involved in mergers and acquisitions observe how certain types of businesses are valued and sold and

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over time patterns emerge. Based upon these empirical data they derive and publish rules of thumb to guide the valuation of businesses by industry and type. Examples of such rules of thumb are: dry cleaning businesses sell from 75 percent to 90 percent of gross...