One of the most frequent questions I get is, “what are the 5 methods of valuation to value my Lubbock business.” Unfortunately, there are not just five methods of valuation. There are, however, almost 30 valuation methods that business appraisers in Lubbock often use to value a company. Not all valuation methods need to be applied to value a Lubbock business. In this article, we will address the three valuation approaches to valuation and the most common methods applied under each approach.
Lubbock business owners frequently have the need or desire to establish a value for their business, and there are many reasons for valuing a small company. Professionals involved in valuing closely-held businesses in Lubbock know its not a simple task. The complexity is further compounded by the fact that each Lubbock business owner’s purpose, motive, and goal in valuing the business varies greatly from those of others. No two businesses are alike; therefore, no one size fits all. The effect these issues may and usually do have on the valuation process gives rise to the concept that the valuation process is more of an art than a science.
The soundness of a particular valuation method is entirely based on the relative circumstances involved in each individual case. The valuation analyst responsible for selecting the most appropriate valuation method must base his or her choice of methods on knowledge of the details of each case. The commonly used methods of valuation, which can be applied to any Lubbock business, can be grouped into one of three general approaches, as follows:
- Asset-Based Approach
- Book Value Method
- Adjusted Net Asset Method
- Income Approach
- Capitalization of Earnings/ Cash Flow Method
- Discounted Earnings/Cash Flows Method
- Market Approach
- Guideline Public Company Method
- Comparable Private Transaction Method
- Dividend Paying Capacity Method
- Prior Sales of interest in subject company
The Adjusted Net Asset (ANA) Method is the more common valuation method applied under this approach. This method is used to value a Lubbock business based on the difference between the fair market value of the business assets and its liabilities. Generally, this method sets a floor value for an operating business because it does not address the operating earnings of the company. The Adjusted Net Assets Method is a sound method for estimating the value of a non-operating business in Lubbock, such as a holding or investment company. It is also a good method for estimating the value of a business that continues to generate losses or which is to be liquidated in the near future.
The Income Approach is defined as a general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount. The Income Approach is the gold standard in valuation, and the valuation methods applied under this approach are generally the best way to value a Lubbock business.
The Capitalization of Earnings/Cash Flows Method is used to value a business based on the future estimated benefits, normally using some measure of earnings or cash flows to be generated by the Lubbock company. These cash flows are then capitalized using an appropriate capitalization rate. This method assumes all of the assets, both tangible and intangible, are indistinguishable parts of the business and do not attempt to separate their values. This method is more theoretically sound in valuing a profitable business in Lubbock where the investor’s intent is to provide a return on investment over and above a reasonable amount of compensation, and future benefit streams or earnings are likely to be level or growing at a steady rate.
The Discounted Earnings/Cash Flow Method is sometimes referred to as the Discounted Cash Flow Method, which suggests the only type of earnings to be valued, using this method, would be some definition of cash flow, such as operating cash flow, after-tax cash flow or discretionary cash flow. This valuation method does not limit the definition of earnings only to cash flows. When done correctly, this is the best valuation method to value a Lubbock company. However, it is also one of the most challenging valuation methods. This valuation method contains the following steps:
- Determine the estimated future earnings of the Lubbock based company
- A terminal or residual value is often determined at the end of the fifth year. The terminal value that is often used is merely the fifth-year projected into perpetuity.
- The discount rate determined incorporates an appropriate safe rate of return, adjusted to reflect the perceived level of risk for the business being valued.
- The estimated future earnings and the terminal value are then discounted to preset using the discount rate determined in step 3 and summed. The resulting figure is the total value of the Lubbock business using this valuation method.
The idea behind the Market Approach when valuing a Lubbock business is that the value of the business can be determined by reference to reasonable comparable guideline companies (comps) for which transaction values are known. These values may be known because these companies are publicly traded or because they were recently sold, and the terms of the transaction were disclosed. There are many pros and cons when valuing a Lubbock business using the various methods under this approach, including:
- It can be user friendly
- It uses actual data
- It is relatively simple to apply
- It does not rely on explicit forecasts
- Sometimes, no recent comparable company data can be found
- The standard of value may be unclear
- Most of the important assumptions are hidden
- It is a costly approach to apply
- It is not as flexible or adaptable as other approaches
- The reliability of the transaction data is questionable
No matter which valuation method you choose to apply to your Lubbock business, sanity checks are a must. Most rules of thumb in textbooks, trade publications, and other sources presume an average business.