How is a Business Valued?

Understanding the Basics of Business Valuation: Standards and Approaches

Whether you’re buying or selling a business, dividing marital assets in a divorce, or planning for succession, understanding the value of a business is essential. Business valuation is a financial analysis process used to determine what a business is worth—and the result can vary significantly depending on the purpose and context. In this post, we’ll break down the fundamentals: the key standards of value and the three primary valuation approaches.

Standards of Value: What Are You Measuring?

Before we can answer “What is this business worth?” we need to clarify: To whom and under what circumstances? That’s where the standard of value comes in. The standard of value defines the perspective from which the business is valued. The most common standards are:

Fair Market Value (FMV)

Fair Market Value is the price at which a business would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts. FMV assumes an open and competitive market and is frequently used in tax matters and divorce cases.

Fair Value

Fair Value is often defined by statute or court precedent and varies by jurisdiction. In the context of shareholder disputes or divorce proceedings, fair value may exclude certain discounts (like discounts for lack of marketability or minority interest). It typically reflects the value to the owner rather than what could be realized on the open market.

Investment Value

Investment Value is the value to a particular investor, based on individual requirements, expectations, or synergies. This standard is often used in strategic acquisitions, where the buyer might be willing to pay more because of expected efficiencies or integration benefits.

Valuation Approaches: How Do We Measure It?

Once the standard of value is established, a valuation professional selects the appropriate valuation approach. There are three widely accepted approaches:

1. Asset Approach

This method values the business based on the value of its assets minus its liabilities. It’s particularly useful for holding companies, capital-intensive businesses, or companies that are not operating profitably.The most common version is the Adjusted Net Asset Method, where the balance sheet is adjusted to reflect the fair market value of assets and liabilities. This approach is less applicable for service-based or income-generating businesses where intangible value (such as goodwill) plays a large role.

2. Market Approach

The market approach compares the business to similar companies that have been sold or are publicly traded. It’s grounded in the principle of substitution: what are similar businesses selling for?Two common methods under this approach include:- Guideline Public Company Method: Using valuation multiples (like price-to-earnings) from public companies in the same industry.- Guideline Transaction Method: Using data from actual sales of comparable private businesses.This approach can be powerful when reliable comparables are available, though adjustments are often needed to reflect size, risk, and growth differences.

3. Income Approach

The income approach estimates the present value of the business's expected future economic benefits. It’s ideal for companies with predictable earnings or cash flow.There are two primary methods:- Capitalization of Earnings/Cash Flow: Used when earnings are stable. It divides the expected earnings by a capitalization rate.- Discounted Cash Flow (DCF): Used when earnings are expected to vary over time. Future cash flows are projected and discounted to present value using a discount rate that reflects the business’s risk.The income approach is widely used in valuing operating businesses and allows for detailed modeling of growth, risk, and capital needs.

Conclusion

Business valuation is both an art and a science. The choice of standard of value and valuation approach depends on the purpose of the valuation, the nature of the business, and the availability of reliable data. Whether you're a business owner, investor, attorney, or financial professional, understanding these basics will help you navigate valuation discussions with more confidence and clarity.