Opinion: Business valuation: A strategic tool

Brittany K. Hopp

Regardless of whether a business is an overnight success, has experienced slow and steady growth or something in-between, every business owner at some point wonders: “How much is this thing worth, anyway?” 

Unfortunately, most owners ask this question late in the game, when they are ready to begin their exit. Unlike financial statements or tax returns, a valuation is a tool that looks forward and attempts to quantify what a business will do in the future.

Contrary to popular belief, there is no hard and fast rule or multiple of what a specific business is worth. Business valuation is often described as both an art and a science – it requires in-depth analysis of financial reports and metrics, paired with a valuator’s judgment. When used properly, a business valuation can give valuable insight to a business owner on what the business is worth at a specific point in time, as well as levers, pain points and areas of opportunity to maximize value in the future.

The first step to a quality business valuation is to get to know the business. This will include an in-depth review of the business’s financial statements and tax returns, bylaws and/or ownership agreements, contracts, key employees and more. The analysis will look at trends over time, as well as compare the business to its industry and the overall economy.

To ensure the valuator is comparing apples to apples, the financial statements will be normalized. This means that any financial transactions that are owner-discretionary or nonoperational will be adjusted. This could be an owner’s salary that is high or low compared with industry averages for the same services rendered, adjusting large charitable donations out of expenses or adjusting rent paid to a related party to fair market value.

After the financial statements are normalized, they are used to calculate the value of the business. There are three widely recognized approaches to valuing a business: the income approach, the asset approach and the market approach. A valuator should look at all three approaches and may use a blended method to reach a conclusion.

The income approach considers the operations of the business – its revenue, expenses and other cash flow figures – to arrive at the expected future annual cash flow. The value is calculated using the expected annual cash flow with a capitalization rate (expected rate of return for that industry). This value represents an amount that, if invested today (at the expected rate of return), would yield the business’s expected future annual cash flow.

The asset approach looks at the assets the business owns – cash, accounts receivable, inventory and fixed assets. The valuator begins with the balance sheet, which records assets at cost. Each asset is adjusted to fair market value – for example, real estate’s value is often increased, while office equipment is often adjusted to a lower value. Intangible assets, such as patents or customer lists, are also accounted for under this approach. The total fair market value is added up to arrive at the final value estimate.

The market approach uses similar businesses that have sold to compare to the subject business’s metrics. For small- to medium-sized businesses, this approach is often tricky to implement, as it is difficult to find relevant, comparable business sales. The final value estimate is often based on a price to revenue multiple.

A valuator looks at these different approaches and selects a mix that makes sense for the specific business. The final valuation conclusion can use various approaches, discounts or premiums to arrive at a value or range of values for the business, as of a specific date. This valuation can then be used for strategic planning, succession planning, estate planning, gifting and charitable donations.

A business owner could need a valuation for many more reasons than curiosity alone. When deployed strategically, a business owner can use the information provided by a valuation to get ahead of any problem areas and maximize future growth.

In a world where it feels like we are often in an information-overload, a valuation should be considered an important tool in any business owner’s toolbox.

Brittany K. Hopp is a partner at Elliott, Robinson & Co. LLP. She can be reached at bhopp@ercpa.com.