INCOME STATEMENT METHODS OF VALUATION
Valuation is the process of putting a price on a piece of property. The value of businesses, personal property, intellectual property (such as patents, trademarks, and copyrights), and real estate are all commonly determined through the practice of valuation. Businesses are valued for many tax, legal, and business reasons but selling the business is the usual motive. Determining the value of a business is simple yet complex.
The value is what a knowledgeable buyer is willing to pay for it. And what price should a buyer be willing to pay? Here things become complicated. More than one valuation method exists but each one must take future earnings into account if continued operations are planned.
The two related valuation methods listed below are by far the most frequently used means of assessing the value of a small business.
- Historical Cash Flow Approach—This is the most commonly used of all valuation methods. Many buyers view this method as the most relevant of all valuation approaches for it tells them what the business has historically provided to its owners in terms of cash. Lawrence Tuller noted in The Small Business Valuation Book, “the value of assets might be interesting to know, but hardly anyone buys a business only for its balance sheet assets.
- The whole purpose is to make money, and most buyers feel that they should be able to generate at least as much cash in the future as the business yielded in the past.” This method typically takes financial data from the company’s previous three years in drawing its conclusions.
- Discounted Future Cash Flow (DCF) Approach—This method uses projections of future cash flows from operating the business to determine what a company is worth today. The DCF approach requires detailed assumptions about future operations, including volumes, pricing, costs, and other factors.
- DCF usually starts with forecast income, adding back non-cash expenses, deducting capital expenditures, and adjusting for working capital changes to arrive at expected cash flows. The future cash flow method also is notable for its recognition of industry reputation, popularity with customers, and other “goodwill” factors in its assessment of company value.
- Once the value of the business’s assets has been settled upon, the appropriate discount rate must be determined and used to bring the future cash flows back to their present-day value.
- DCF in its single-period form is known as capitalization of earnings, which usually involves “normalizing” a recent measure of income or cash flow to reflect a steady-state or going-forward amount that can be capitalized at the appropriate multiple.