Answers to Top 3 Questions on Business Valuation Approaches
Over the past several years, we have presented CLEs on business valuation to local law firms. Here are a few of the more common questions that have come up on preferred business valuation approaches and methods along with our answers to those questions.
- I assume buyers would prefer a valuation method that results in a higher value, and sellers would prefer a business valuation method that results in a lower value. Which business valuation approaches are generally preferred by buyers and sellers?
ANSWER: We have three approaches to business valuation: Income, Market, and Asset Approaches. Each approach has one or more methods that fall under it. It is common practice in a business valuation to apply two or more valuation methods and obtain two or more indications of value.
It is important to note that it is not typically the method itself that may lead to a lower or higher value, but the inputs used in the methods, which include:
- Adjustments that are made to the earnings before applying valuation approaches and methods;
- Forecasted future earnings and the discount and capitalization rates applied to them in the Income Approach;
- Valuation multiples and the earnings base to which those are applied in the Market Approach;
- Estimated values of the fixed assets and other assets in the Asset Approach and which liabilities are subtracted, including contingent liabilities; and
- Whether the business had excess cash or non-operating assets, or a working capital deficiency.
- Which methods are preferred for different types of businesses?
ANSWER: Theoretically, all valuation methods are applicable to value any type of business. That being said, certain business valuation methods may be a better fit for certain types of businesses. For instance, businesses with very few fixed assets, such as service businesses, are typically valued by methods under the Income and Market Approaches. These methods include the Capitalization Method under the Income Approach and the Guideline Transaction Method under the Market Approach. See Using Comparable Businesses to Value Your Own Company. When valuing more asset-intensive businesses, such as a manufacturer of machinery, we would typically utilize the Asset Approach, in addition to the Income and Market Approaches. See our piece on Which Valuation Approach is Best for a Manufacturing Company.
Typically, the Income and Market Approaches are preferred and given more weight for operating businesses, while the Asset Approach is attributed more weight for an asset-holding company, such as an LLC holding real property. Note that these are broad rules, and every business is valued on a case-by-case basis. For organizations with complex ownership structures, we also discuss the Three Keys Things to Know About Business Valuation of Multi-Tiered Entities.
- What method would you use to value a professional company, such as a medical practice or law firm?
ANSWER: Since they are service-based businesses and not usually asset-intensive, we typically use Income Approach methods to value medical or law practices, including the Capitalization Method and the Discounted Cash Flow Method. By accessing databases of medical practice transactions, including the Health Care Group’s Goodwill Registry, we are typically able to use the Market Approach to value medical practices. When valuing law practices, we typically do not use the Market Approach, as there is usually no financial data available on the transactions of law firms. For a medical practice with significant fixed assets, we would typically also utilize an Asset Approach and may enlist the consultation of a machinery and equipment appraiser to value the fixed assets.
If you’re interested in our firm’s CLEs on business valuation, or other topics including expert testimony, financial resolutions of partnership disputes, forensic accounting, and lost profits, please see our CLE offerings and contact us.