Business valuation is the practice of estimating the economic value of a whole business or a partial ownership interest in it. Appraisers work from three broad families of method: the asset approach, which values the business by its net assets; the income approach, which values it by the earnings or cash flow it is expected to produce; and the market approach, which values it against the prices paid for comparable businesses. Because a private business has no daily market price, a valuation is an informed estimate rather than a fact, and the same business can carry different defensible values depending on why it is being valued and which standard of value applies.
Business Valuation
Business valuation is the process of estimating what a business or an ownership interest in it is worth, using recognized methods grouped into asset, income, and market approaches. There is no single correct number; the answer depends on the method, the purpose, and the standard of value.
Last reviewed by Steven Fox, CFP®, EA
on
Quick Summary
- It estimates the worth of a business or a share of one, for purposes such as a sale, a buy-sell agreement, a divorce, or an estate-tax return.
- The three broad approaches are the asset approach, the income approach (including discounted cash flow), and the market approach (comparable sales and multiples).
- The "standard of value" and the purpose change the answer, so a valuation for a tax return can differ from one for a sale.
- Minority and hard-to-sell interests are often reduced by discounts for lack of control and lack of marketability.
Definition
Advanced Explanation
The three approaches answer the same question from different directions. The asset approach adds up the fair value of the business's assets and subtracts its liabilities; it suits holding companies and businesses worth more dead than alive, and it tends to understate a profitable operating business whose value is in its earnings rather than its equipment. The income approach projects the business's future earnings or cash flow and converts them to a present value, either by capitalizing a single representative year's earnings or by discounting a multi-year forecast of cash flows back to today. The market approach applies multiples drawn from sales of comparable businesses, such as a multiple of earnings or of revenue, and from any transactions in the subject company's own shares. A thorough valuation usually considers more than one approach and reconciles them rather than trusting a single figure.
Two ideas separate a real valuation from a rule-of-thumb multiple. The first is the standard of value, the definition of "value" the assignment requires: fair market value (the price between a willing buyer and seller) for tax and many legal purposes, fair value for certain shareholder disputes, and investment value for a particular strategic buyer, each of which can produce a different number for the same business. The second is discounts and premiums. An interest that cannot control the business is commonly reduced by a discount for lack of control, and an interest with no ready market is reduced by a discount for lack of marketability; together these can lower the value of a minority stake well below its proportionate share of the whole. Valuations feed directly into other decisions: a buy-sell agreement fixes a value or a method for pricing an owner's interest, an estate-tax return must report a defensible fair market value, and a sale negotiation starts from one. Where the number carries tax or legal consequences, a qualified appraiser is often necessary rather than optional, because a poorly supported value invites challenge.
Used in a Sentence
“Before listing the manufacturing company for sale, the owner commissioned a business valuation that used both an earnings multiple and a discounted cash-flow analysis to set a defensible asking price.”
How It Works
An appraiser establishes the purpose and standard of value, gathers financial statements and normalizes them for one-time and owner-specific items, applies one or more of the asset, income, and market approaches, adjusts for control and marketability, and reconciles the results into a supported conclusion of value.
A hypothetical example using the income approach: a business produces about $500,000 a year in normalized, recurring earnings, and comparable sales suggest a multiple of four times earnings for a business of its size and risk. Four times $500,000 is a $2,000,000 enterprise value. If the interest being valued is a 25% minority stake, its proportionate share is $500,000, but an appraiser might apply, say, a 15% discount for lack of control and a 20% discount for lack of marketability, which combine multiplicatively to reduce $500,000 by about 32% to roughly $340,000. The discounts, not the arithmetic, are where valuations are most often contested.
Pros and Cons
Pros
- Provides a supported, defensible estimate of value for a sale, a buy-sell agreement, a divorce, or an estate-tax filing.
- Multiple approaches cross-check one another and expose an unrealistic price.
- A qualified appraisal is harder for the IRS or an opposing party to challenge than a rule-of-thumb figure.
Cons
- A private business has no market price, so any valuation is an estimate that reasonable experts can dispute.
- The result shifts with the purpose and the standard of value, so one number does not fit every use.
- Discounts for lack of control and marketability are judgment calls and a frequent source of disagreement.
- A quality valuation costs money and takes time.
People Also Asked
Answers to the most frequently asked questions.
What are the three approaches to business valuation?
The asset approach values the business by its net assets, the income approach values it by the earnings or cash flow it is expected to generate (including discounted cash flow), and the market approach values it against the prices paid for comparable businesses. A careful valuation usually considers more than one and reconciles them.
Why can the same business have more than one value?
Because value depends on the purpose and the "standard of value" applied. Fair market value for a tax return, fair value in a shareholder dispute, and investment value to a specific strategic buyer can all differ for the same business, and discounts for a minority or hard-to-sell interest change the number again.
What are marketability and control discounts?
A discount for lack of control reduces the value of an interest that cannot direct the business, and a discount for lack of marketability reduces the value of an interest that has no ready market to sell into. Applied to a minority stake in a private company, they can bring its value well below a simple proportionate share of the whole, and they are often the most contested part of a valuation.
When do I need a formal business valuation?
A formal, qualified valuation is generally warranted when the number carries tax or legal weight, such as an estate or gift-tax return, a buy-sell transfer, a divorce, or a sale. For those uses a supported appraisal is far more defensible than a rule-of-thumb multiple if the figure is later challenged.
Have a question a definition can't answer?
Advice-only advisors answer questions like this for a transparent flat fee — no products, no commissions, no asset management.
Find an Advisor