Simply stated, the asset approach values the assets of the business. The value of the assets of a business are, however, not always easy to ascertain. For example, the value of the assets as stated on the Balance Sheet -- "Book Value" - is almost always not the true value of the assets in the marketplace. If a business is being liquidated and the assets must be sold by next Friday, then Book Value is not of importance. However, if the assets can be sold over a course of several months, then the value of these assets is closer to their fair market value (FMV). Most of the time assets are valued at FMV, defined as the price that a reasonable buyer would pay a reasonable seller when neither were under pressure to buy or sell. Unless you are buying a business that is very asset intensive, marginally profitable, or losing money, the asset approach usually is not the best indicator of the true value of the business.
The
income approach uses one or more methods to determine the value based upon
the anticipated benefits of business ownership. Simply stated, the income
approach determines the value of the anticipated stream of business income.
While entire books have been written on this subject, the most relevant discussion
revolves around what are the earnings and what is the discount rate or capitalization
rate applied to the earnings? Earnings, as discussed elsewhere, are the adjusted
profits of the business. Most
professional valuations use one of two types
of earnings: 1) SDCF,
or Seller's Discretionary Cash, is a direct
measurement of the true bottom line benefit
of owning a small business. SDCF includes
the owner's salary or take home compensation; 2) EBITDA,
or earnings before interest, taxes, depreciation,
and amortization. EBITDA differs from SDCF
in one key area; it includes compensation
for management. Discount or Capitalization
Rates can vary greatly by the type of business,
type of prospective purchaser and the
overall risk of the continuity of the income
stream. Depending on the buyer and the business,
some potential areas of risk can be the
size of the company, competitive forces,
barriers to entry, growth rates, lack of
management, etc. As a broad brush example
of risk, an investor investing in a portfolio
of stocks representing the entire stock
market may believe that an 8% rate of return
is adequate given the enormous diversification
in industry, size, and given that these
publicly held companies have top quality
management. On the other hand, a potential
buyer of a beauty salon may seek a 50% rate
of return given the large number of competitors,
high employee turnover, low barrier to entry,
and the necessity of constant supervision. The market approach determines the value of a business by comparing it to
similar businesses that have been sold. Although not as complete or comprehensive
as residential comparable sales, there are several very good databases of
sold businesses. Businesses are seldom exactly the same, but grouping like
businesses by type and or region makes comparisons relevant. VR subscribes
to these databases and often checks numerous sources to find like businesses.
Ratios considered when using the market approach are the price to earnings
and price to revenue.
No discussion on how to value a business,
but there are some basic facts about approaches to valuation that will help
you better understand the process and its results.Asset Approach
Income Approach
Market Approach
How To Value A Business
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more information.