When a business is being sold a value has to be estimated in order to set the sale price. Although the broker or investment banker will often provide input into the asking price and ultimate sale price of the business, the decision as to the price is the seller’s. Therefore, the seller should be familiar with accepted approaches and methodologies for valuing businesses for sale.
A seller should realize that business valuation is more of an art than a science and that different people can have very different opinions as to value. This is due to the fact that many subjective judgments have to be made in valuing a business. Judgments have to be made as to reasonable owner’s compensation, other reasonable discretionary expenses, long-term growth in earnings, the risk level of earnings, strength of management, level of competition, the anticipated success of new products, etc.
A seller should also realize that despite what he believes the value of the business is, it is only worth what a buyer is willing to pay for it. Thus, care should be taken in estimating a reasonable value, or the business might not sell at a level near the asking price.
As with the valuation of a business for any other purpose, the three main approaches to valuation are the income approach, the market approach and the cost or asset approach.
When valuing a business for sale, the income approach usually involves performing a discounted cash flow analysis on the subject company’s projected financial statements. If no projections are available, historical earnings are often capitalized if they are a reasonable proxy for future earnings. Key (and somewhat subjective) decisions under this approach include the determination of the discount rate, the long-term earnings growth rate and the earnings to be capitalized. The greater the risk associated with the earnings being capitalized the greater the discount rate.
When valuing a company for sale under the market approach, the sale prices of “comparable” companies are analyzed in relation to their financial data. The sale prices can be compared to revenues, earnings, cash flow, EBIT (earnings before interest and taxes), EBITDA (EBIT + depreciation and amortization expense) or many other measures. Data on comparable companies is usually derived from databases that report the sales prices and financial data of public and private companies. However, the data is usually limited on private companies and public companies are often not comparable to the subject private company, due to their larger size and greater liquidity.
A business is normally valued for sale under the cost or asset approach when earnings are low or negative and the value of the company’s assets is the best indicator of the company’s value. In these situations, the prospects of the company are often hard to estimate and, thus, a seller uses asset value, net of liabilities, as a fallback value. However, assets are only valuable to a company if they can generate earnings, so the prospective earnings must provide a sufficient return on the value of the assets to make them a reasonable indication of value.
One method that should not be used is the "rule of thumb". In this method, businesses are often said to trade at 10 times net income, or 5 times EBITDA or any number of other rules of thumb. The problem with rules of thumb is that they assume that all businesses in a particular industry will trade at the same multiple. However, in reality, many businesses sell at multiples much higher than the rules of thumb and much lower as well. For instance, a company with a high level of growth will often trade at a high multiple, while one with high risk will often trade at a low multiple. A rule of thumb should only be used as a cross-check on value.
Conclusion
In summary, whatever approach is used, reasonableness is the key to estimating an acceptable value. At every decision point in the valuation process it is important to be reasonable and to document why the decision was made. Therefore, when the buyer inquires as to why the business was valued as it was, an explanation can be made for every decision leading to the value. This will go a long way in getting a sale near the asking price.
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