Business Valuation Approaches (www.valuadder.

com/glossary/business-valuation-
approaches)

DefinitionGenerally accepted ways of determining the value of small businesses and

professional practices.

What It MeansThere are three broad approaches used for small business valuation. Each
approach serves as a foundation for a group of methods used to determine the business value.

 Income approach
 Asset approach
 Market approach

A comprehensive business valuation model should include a choice of several methods under the
above approaches.

I -Income approach to business valuation The Income approach methods determine the value
of a business based on its ability to generate desired economic benefit for the owners. The key
objective of the income based methods is to determine the business value as a function of the
economic benefit.

The economic benefit such as the seller's discretionary cash flow or net cash flow is capitalized,
discounted or multiplied to perform the valuation. Key to the effective use of the income-based
business valuation methods is the proper selection of the capitalization rate, discount rate, and
valuation multiples. The well known methods under the income approach are:

 Discounted cash flow method

 Capitalization of earnings method
 Multiple of discretionary earnings method

*Explicarea si modelarea termenilor:

1-Seller's Discretionary Cash Flow Definition The pre-tax earnings of the business before
non-cash expenses, one owner's compensation, interest expense or income, as well as one-
time and non-business related income and expense items. If there are additional owners
working in the business, their compensation needs to be adjusted to market rates. What It
Means Seller's discretionary cash flow or SDCF is a common cash flow based measure of
business earnings for owner-operator managed businesses. According to the International
Business Brokers Association, SDCF can be determined as follows:

 Start with the business pretax earnings.

 Add non-operating expenses and subtract non-operating income.
 Add unusual or one-time expenses, subtract non-recurring income.
 Add depreciation and amortization expenses.
 Add interest expense, subtract interest income.

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  Add a single owner's total compensation.
 Adjust compensation of all other business owners to market value.

 Using SDCF in business valuation

 I. Multiple of discretionary earnings method

 SDCF is used as the income basis for the Multiple of Discretionary Earnings business
valuation method.

2- Net Cash Flow Net cash flow is a measure of economic income used as a basis in the
Discounted Cash Flow business valuation method.

What It Means For the purposes of small business valuation the net cash flow is what the
business owners can remove from the business without adversely affecting its operations.

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Net cash flow to total invested capital Assuming that both debt and equity capital is used to
fund business operations, the net cash flow is calculated as follows:

 Start with the net after-tax income.

 Add the depreciation and amortization expenses.
 Add the after-tax portion of the interest expense.
 Subtract the business capital expenses. Historic requirements can be found on the
company's Statement of Cash Flows.
 Subtract increases in working capital.

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Depreciation A non-cash business expense which is recorded on the Profit and Loss Statement
representing the rate of consumption of the firm's long-term assets.

What It Means As a business uses its assets such as machinery and equipment, they are
gradually worn out and must eventually be replaced. The business is allowed to claim
depreciation of such assets as a non-cash expense thereby reducing its taxable income. The idea
is that this allows businesses to set aside a certain amount of cash in anticipation of assets
replacement.

Amortization The regular installment payment schedule established to pay off a debt.

Capital expense deduction of a long-term business asset, similar to depreciation.

What It Means Interest The periodic rate received by the creditor on the money loaned.

What It Means The interest is the premium the lender receives in exchange for offering the
money to the borrower. The interest is established as a percentage of the money loaned, called
the principal.

Interest is a tax-deductible business expense, which makes the cost of debt capital cheaper than
equity. However, the requirement to make the debt installment payments regularly must be met
for successful business operation.

This is especially important if a small business is purchased with borrowed money, such as
seller's note or bank financing. The ability of a business to meet its debt obligations is measured
by the debt service coverage ratio.

Working Capital Definition The difference between the current assets of the business and its
current liabilities.

What It Means Working capital represents the funds required to conduct daily business
operations. It shows what readily available resources the business has at its disposal in order to
meet the obligations coming due in the short term. The ratio of the current assets divided by
current liabilities is known as the current ratio. It represents a key liquidity measure of business
solvency.

Accounting for adequate working capital is an essential element of buying a small business. For
many small businesses, the working capital needs change throughout the year. As a business
buyer you need to determine what these seasonal fluctuations are, and provide for sufficient
working capital at all times.

3-Business Valuation Methods

Definition A set of procedures or techniques used to determine the business value.

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What It Means Under each of the three broad approaches to business valuation, there are a
number of procedures, called business valuation methods, which you can use to calculate the
business value.

The methods under each business valuation approach rely upon the same set of economic
principles. However, the procedural and mathematical details of each business valuation method
may differ considerably.

4- Capitalization Rate Definition A value, typically expressed as a fraction, used to divide

a business economic benefit to arrive at the business value.

What It Means Capitalization rate or Cap rate, is a divisor used to convert a single-point
business economic benefit into the business value. The typical economic benefit used in business
valuation is business earnings such as the seller's discretionary cash flow, net cash flow or
EBITDA.

Note that the Capitalization rate is the reciprocal of the business valuation multiple which is
used by the Multiple of Discretionary Earnings business valuation method.

5- Discount Rate Definition The interest rate that is used in the Discounted Cash Flow
business valuation method to determine what the expected business income stream is worth
in present day dollars.

What It Means The discount rate represents the required rate of return to make a business
acquisition worth while. The idea is to look at a business purchase as an investment decision.
Given that point of view, the business purchase investment must be compared against other,
possibly safer, alternatives.

For example, if you could invest in the US Government bonds at 5% annual return, then the
business must produce returns that are higher, in order to account for the risks of owning and
operating the business.

Business Appraisal by Discounting its Cash Flow

Valuing a Business based on Cash Flow and Risk

Preferred by professional business appraisers and savvy investors, the Discounted Cash Flow
method lets you determine the value of a business based on three fundamentals:

1. Business cash flow stream.

2. Discount rate which captures the business risk.
3. Long-term (terminal) business value.

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Accurate valuation of businesses large and small Discounted Cash Flow is considered the
most accurate business valuation method. Its strength lies in business value estimation based on
the precise match between the business earning power and risk. You can accurately determine
the value of any business – large or small – using this powerful business valuation method

6- Valuation Multiple Definition A value, typically expressed as a factor, used to multiply

a business economic benefit to arrive at the business value.

What It Means Valuation multiple is a multiplier used to convert a single-point business

economic benefit into the business value. The typical economic benefit used in business
valuation is a measure of business earnings such as the seller's discretionary cash flow (SDCF).
Note that the Valuation multiple is the reciprocal of the Capitalization rate.

Business value estimation as multiple of discretionary earnings

Valuation multiples are incorporated into the Multiple of Discretionary Earnings income-based
business valuation method. The multiples are calculated based on the assessement of a set of
financial and operational factors. (Earnings Multiple calculates your business value according
to these key financial and operational areas:

Earnings track record/Industry growth prospects/Business growth prospects/Deal financing/

Competition/Location/Customer concentration/Product/service concentration/Market
concentration/Nature of business/Desirability/Ease of operation/Employees Management

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Methods: Discounted Cash Flow method of valuation(“to be used for the first method of
valuation“) Income-based Business Valuation Method

Definition A key income-based small business valuation method that establishes the business
value as a stream of future economic benefits discounted to their present value.

What It Means Discounted Cash Flow method determines the business value by considering
these inputs:

 A stream of expected economic benefits, such as the net cash flows.

 A discount rate which establishes the required rate of return on investment.
 An expected gain from the disposition of the business at the conclusion of the ownership
period, or the long-term (terminal) value.

The objective of the method is to determine what the expected economic benefits stream is worth
in present day dollars, given the risks associated with owning and operating the small business.
Because of the method's solid financial theory foundation, it is favored by seasoned investors and
business valuation professionals.

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Business appraisers and economists sometimes use the formal name Discounted Future
Economic Income when referring to the Discounted Cash Flow business valuation method.

The reason is that this method is quite flexible with the choice of the income measures that can
be used as its input. Key to the method's accuracy, though, is a careful match between the
income measure, known as the earnings basis, and the discount rate.

(modificarea termenilor “terminal value “ si gain on business sale”).

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II- Asset approach to valuing a business

The Asset approach methods seek to determine the business value based on the value of its
assets. The idea is to determine the business value based on the fair market value of its assets less
its liabilities. The commonly used valuation methods under this approach are:

 Asset accumulation method

 Capitalized excess earnings method

*Explicarea termenilor si exemplificarea datelor numerice:

1- Fair Market Value Definition Definition When referring to the transfer of a business asset,
the fair market value is defined as a monetary amount that a buyer may reasonably offer, and a
seller accept, in exchange for the asset. What It Means The fair market value of an asset is
established when a willing business buyer and a willing seller reach an agreement, with both
parties acting in full knowledge of all facts and not being forced to conclude the transaction by
circumstances.

2- Liabilities DefinitionLegal obligations of the business, which appear on its Balance

Sheet. What It Means Liabilities are debt carried by the business and include such items as

 Accounts payable
 Loans
 Deferred revenues
 Accrued expenses

Those liabilities that must be paid within one year are referred to as current liabilities, the rest are
called long-term liabilities. When valuing a small business for sale, you may need to recast its
financials, including the liabilities.

2.1 Recast Financial Statements Definition Financial statements of the business that are
adjusted to reflect the actual financial benefits of business ownership.

What It Means Most small businesses are managed to minimize taxable income. Thus, it is
often necessary to make adjustments to the reported financial statements in order to express the
actual cash flow benefits available for the owner. Adjusting the business financial statements
facilitates its comparison to the industry standard ratios. -

3 Asset Accumulation (to be used as a secondary method of valuation/ asset-based)

Business Valuation Method

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Definition A widely used asset-based small business valuation method that determines the
business value as the difference between the current value of all business assets and the current
value of all its liabilities.

What It Means While the Asset Accumulation Method uses the familiar balance sheet
format, the business value result is very different from the cost-basis historic company "book
value". Fair market value of all business assets, both tangible and intangible is determined.

Next, both recorded and contingent business liabilities are valued using the fair market value
standard. The difference between the sum total of the asset value and liability value thus
determined establishes the value of the business.

Some off-balance sheet assets that are included in the Asset Accumulation valuation are:

 Intellectual property items, such as internally developed products and services.

 Key distribution and customer contracts.
 Strategic partnership agreements.

Typical unrecorded liabilities that are included in the valuation are:

 Pending legal judgments.

 Property and income tax obligations.
 Environmental compliance costs.

Asset Accumulation Method is very useful when allocating the purchase price among the
individual business assets, as part of the asset purchase agreement. However, proper application
of the method requires considerable expertise in asset and liability valuation.

4- Business Goodwill Definition That part of business value over and above the
value of identifiable business assets.

What It Means Business goodwill is a key intangible asset that represents the portion of the
business value that cannot be attributed to other business assets.

Put differently, business goodwill reflects the synergy among the various assets used by the
business to produce income: in a well-run business the whole is greater than the sum of the parts.

What creates business goodwill Here are the key factors that contribute to the creation of
business goodwill:

Going concern value Excess business income Expectation of future economic benefits

Capitalized Excess Earnings Asset-based Business Valuation Method

Definition A common asset-based small business valuation method that determines the business
value as the sum total of the business net tangible assets and its intangible value or goodwill.

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What It Means Capitalized Excess Earnings method determines the business value by
summing the net tangible value of the business assets with the capitalized value of the "excess"
earnings. A typical procedure to establish the business value with the method is:

 Start with the business net tangible assets, obtained from its recast financial statements by
subtracting adjusted liabilities from the tangible assets.
 Estimate the business earnings attributable to the net tangible assets. This is done by
multiplying the net tangible assets by a reasonable rate of return, expressed as a
percentage.
 Determine the excess earnings as the difference between the total business earnings and
those attributable to the net tangible assets. These excess earnings reflect the business
goodwill.
 Capitalize the excess earnings by dividing their value by an appropriate capitalization
rate.
 Add the capitalized excess earnings value to the value of the business net tangible assets,
to establish the overall business value.

Capitalized Excess Earnings method is often called the Treasury Method because it was first
introduced by the US Treasury Department in the 1920's to value business goodwill. It is
described in the Appeals and Review Memorandum Number 34. Widely adopted by the
professional appraisal community, this method has been further clarified in the US Internal
Revenue Service Ruling 68-609. Business Value = Assets + Business Goodwill

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