There are three basic approaches to valuation. The Market Data Approach uses market comparables to value a business based upon price to earnings and price to revenues from similar types of businesses that have actually sold. The Income Approach basically values the income stream of the business. And the Asset Approach, as the name suggests, values the assets of the business. Pretty simple right?
Where many people get off track is when they mix these approaches. They want to use the value indicated in the income or market approach, then add the value from the asset approach. But unfortunately business valuation usually doesn’t work like this. Otherwise, I could sell my house for the same price per square foot as my neighbor did, then add the cost of all the building materials used to build the house in the first place.
The fixtures, equipment, and the inventory are all assets that enable to the business to earn a profit. If we are selling the business for a multiple of that profit, it assumes that whatever assets were needed to drive those profits are included.
I often use a jewerly store as an example. Let’s say the store has $1MM in watches, diamonds, and gold inventory. It takes that much because they need to have a nice selection and they need to buy in bulk to keep their prices down. But say the owner of the business works full time and only earns $50k for their full time efforts. What’s this business worth?
Well if you mix and match, you will come up with a valuation over $1MM right? But who is going to invest $1MM to earn 5% ($50K) on their investment, plus have to work in the business full time? The answer of course is nobody.
One last thing to keep in mind about valuation. You can come up with any formula you like to value the business. But for a business to sell, GENERALLY you have to have these three components:
1. The business must be able to provide a living wage to the working owner operater.
2. The business must generate enough profit to service the debt used in acquiring it.
3. The business must generate a return on the buyer’s investment.
If you have these three ingredients, usually you have a business that can be sold.