There are many different ways to work out the value of a business. For the small to mid-size business, there are 3 main approaches that are used more than others. These are the Income value, Market value and the Asset value.
In brief, these would be described as follows:
Valuation based on income: Here one is looking at the potential earning power of the business into the future. Past earnings, expected future growth, owner compensation adjustments, and specific risk factors, such as customer concentration, weak management and lack of diversification are all taken into account when income based valuations are used.
Market Valuation: This method of valuing a business is similar to the way one values a house when selling it. What is being looked at here is what the market will pay for the business in question. Basically, one collects information on the sale of comparable businesses within the industry that the business is in.
In both Income valuations and Market valuations, we will find a price multiple. This is usually price divided by gross sales and price divided by earnings. The applicable price multiple is selected primarily on the profitability of the business. For example, a business with high profits would have a higher price multiple applied to it. A business with low profits would be assigned a lower price multiple. When using this approach, one gets a more accurate result when one uses a minimum of about a dozen comparables.
Asset valuation: This valuation procedure assumes that a business is worth the fair market value of its tangible (physical) assets plus its intangible assets. Then from these total assets, liabilities or debts are deducted. To value a business that has intangibles, several methods are used. The method that is most employed in this area is the 5-step excess earning calculation. That calculation deals with tangible assets, intangible assets, liabilities and adjustments thereof, to arrive at an estimated value for the business. It figures out what the reasonable return is on the assets of the business should be. If the profit is greater, then the business has some intangible assets that are making the excess profit.
If the company in question is not making a lot of money, then there will be no intangible. In this situation, the asset valuation method is usually used when a business has capital tied up in equipment and other tangible assets and the other valuation methods come up with a price below the actual asset value, without any good will. A seller wants to get at least what the equipment is worth; so then this method is used.