Succession planning? Use these tools to assess business value
Knowing the economic value of your business is important – especially when it’s time to start succession planning. Whether you’re looking to assess the fair value of a business for sale or putting your own on the market, here are three common business valuation methods you should know.
1. Earning valuations
Fair value is assessed according to a business’ likelihood of future earnings. Here, we look at a common method known as capitalization of earnings.
A maple syrup farm has generated $200,000 in revenue every year for the past five years and has had annual expenses of $100,000. Its annual earnings are $100,000.
We’ll assume there is no growth in average revenue on the horizon. Future earnings must be adjusted for the risk involved in the operation, the buyer’s aversion to risk and the opportunity cost of the investment in the business. For the sake of the argument, let’s assume the capitalization rate is 10%.
That means the farm’s “earning value” valuation is $1million ($100,000/0.10 = $1,000,000)
2. Market valuations
A market value approach compares the sales values of businesses similar in size, industry, comparable location, and when valuing ag operations, the land quality. This method works well, but only if comparison data is available.
3. Asset-based valuations
The liquidation method simply subtracts the value of a business’ liabilities from its assets, calculating how much cash the business would net by selling all tangible assets and paying off all liabilities.
Asset-based valuations are seldom used to value healthy operations. While it’s often difficult to separate business from personal use of assets (e.g., aircraft used for aerial applications are often dual-purpose use), this valuation method is most often used to assess businesses being liquidated.
Which valuation should you use?
Other valuation methods exist, and most professionals tend to use more than one method. What’s most appropriate however varies by industry and business outlook. Whether looking to sell or buy a farm, plan for family succession, or trying to find new investors, business owners with a strong understanding of the business’ economic value are better situated to negotiate fair terms.
Business owners should always consult with a professional before using the valuation tools above.
Blair Baillargeon, Economics student intern