As a business valuation professional and CPA, I am often my family and friends’ first phone call regarding all sorts of financial questions and concerns. However, the most common question I come by is “How do you value a business?” The answer is far simpler than the application, but it is similar to how a home is appraised or valued.
In my experience, everyone can generally guess the value of their home with surprising accuracy. The increased popularity of real estate apps like Realtor.com and Zillow.com have created amateur home appraisers out of all of us. So, let’s take what we learned from these popular apps and apply them to a business valuation.
There are three generally accepted approaches used in all home appraisals and business valuations; Market Approach, Income Approach and Asset Approach.
The Market Approach is the approach of determining the value of an asset based on the selling price of similar assets. This is the most common approach relied upon for residential home appraisals. We see realtors on popular shows like Property Brothers or House Hunters ask “What are the comps?” ‘Comps’ is short for comparables. To put it simply, the realtor is asking what are similar houses selling for in the area. In practice, the home appraiser will pool several recent sales of similar homes in the area, average those prices by a simple ratio, like dollar per square foot, and then apply that ratio to the home being valued.
The same methodology is true for a business valuation when applying the market approach. The business appraiser will pool several sales of similar businesses, average those prices by a simple ratio related to revenues or earnings and then apply that ratio to the business being valued.
The Income Approach is the approach of determining the value of an asset based on the expected income generated by the asset, adjusted for the risks and costs associated with the purchase and ownership of that asset. This is the most common approach relied upon for business valuations and rental properties. The income approach can be costly and very detailed for a business valuation; however, for a home appraisal it is rather straight forward. In practice, the home appraiser will divide the rental income of a property by a rate that represents the risks and costs associated with that property.
The rate that represents the risks and costs associated with an asset, in this example, is called the capitalization rate. The capitalization rate is calculated by adding the cost of the capital used to purchase an asset and the risks associated with that asset, less the long-term growth rate. For example, a simple rental property capitalization rate, assuming 100% debt financing, could be calculated as the following:
Mortgage Rate 5%
Risk Factors 5%
Long-Term Growth (3%)
Capitalization Rate 7%
To continue our rental property example, if a rental property is estimated to earn $12,000 in rental income per annum with a 7% capitalization rate, the implied value of the rental property is $171,429.
The same methodology is true for a business valuation when applying the income approach. The business appraiser will divide (or capitalize) the projected net income (or other profit metric) of a business by a rate that represents the risks and costs associated with the business being valued. It is important to note, there are additional methods and rates utilized under the income approach for business valuation.
The Asset Approach (or Cost Approach) is an approach of determining the value of an asset based on the costs to reconstruct or replace the asset. This approach is the most common method relied upon for financially distressed companies or companies with a significant amount of fixed assets. The typical home appraisal will not rely upon the value determined from this approach; however, the average home insurance policy utilizes the estimated value to reconstruct or replace one’s home (i.e., the asset approach). If the homeowner reviews their home insurance policy, they will quickly discover their home is not insured for its estimated market value, but instead its estimated cost to reconstruct.
The methodology is a little different for a business valuation when applying the asset approach; however, the principles remain the same. The business appraiser will estimate the fair market value of the companies’ assets, less the estimated fair market value of the companies’ liabilities to determine the companies’ net asset value. In principle, we are determining the costs to reconstruct the company at the current market rates to do so (i.e., the asset approach).
Hopefully, this posting will help increase your understanding of business valuation approaches and how the typical home, or any asset, is appraised or valued.
 Source: https://www.investopedia.com/terms/m/market-approach