Determining the Value of a Business

Before you make any purchase, you want to know what you're paying for, right? The same is especially true when you are acquiring a business. Before purchasing your business, you need to determine the value of the business and determine if there is a profitable future given its current condition.

A realistic business valuation requires more than merely looking at the previous year's financial statement; it requires a thorough analysis of several years of the business operation and an opinion about the future outlook of the industry, the economy, and how the subject company will compete.

How Should I Do My Analysis?

Most people believe that a business should be sold for Fair Market Value. The term Fair Market Value is defined by the IRS at Rev. Ruling 59-60 as follows: "The price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts."

There are a number of different methods to determine a fair and equitable price for the sale of the business. The following lists a few methods to determine the price:

Capitalized Earning Approach: This method refers to the return on the investment that is expected by an investor.
Excess Earning Method: Similar to the capitalized earning method, except that it splits off return on assets from other earnings.
Cash Flow Method: This method is usually used when attempting to determine how much of a loan the cash flow of the business will support. The adjusted cash flow is used as a benchmark to measure the firm's ability to service debt.
Tangible Assets (Balance Sheet) Method: This method values the business by the tangible assets.
Value of Specific Intangible Assets Method: This method is based upon the buyer's buying a wanted intangible asset versus creating it. This method also takes into consideration valuing the goodwill of the business.