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Determining the value of a business can be a tricky process. But given the ongoing economic downturn, many small business owners across the nation are realizing the critical importance of understanding how to accurately assess the fair market value of their company in the event that they consider selling or want to purchase another existing business.
There are three basic approaches for determining the value of a small business.
1. Market Approach. The market approach to valuation derives business value in comparison to historic sales, earnings, and/or assets of other similar businesses. Basically the business is worth the average of what comparable businesses in the same market are worth. This can be a dangerous approach to valuation, however, if your business is not "average."
2. Asset Approach. The asset approach to valuation determines the value of a business by assessing the fair market value of its assets. The basic thought is that no one will pay more for a company’s business assets than it would pay procuring similar assets on its own. While most tangible assets are already reported on the books, determining the value of intangible assets is more difficult.
3. Income Approach. The income approach to valuation, which is most commonly used for valuing small businesses, establishes value by evaluating a business’s ability to generate economic benefit for the owner. An appraiser will start by evaluating the business’s level of earnings (discretionary cash flow, net cash flow, etc.) and then pair it with the right conversion factor (capitalization rate, discount rate or multiple, which is generally between 1 and 3 times earnings) and consider the additional value of the business’s assets to perform the valuation.
Each of these approaches serves as a foundation for a group of methods used to value a business. The one most commonly used by business brokers for the valuation of small businesses falls under the income approach and is called the "multiple of discretionary earnings method." This method is especially well-suited for valuing owner/operator managed businesses.
Accurately determining value can be a complex process and you may want to consider hiring a professional business appraiser to assist you in properly determining a value for you business.