Business Valuation is a process used to estimate the economic value of a business. Business Valuation is used in transactions to determine the price of a business that buyers are prepared to receive, or which sellers are prepared to pay for.
There are various purposes of performing a Business Valuation:
- estimating the value of a business for the purpose of a sale and purchase transaction;
- in a matrimonial litigation involving the couple’s business;
- resolving disputes amongst business partners;
- allocating Purchase Price Allocation amongst business assets;
- many other business and legal purposes
There is no one correct or accurate method to establish what a business is worth. The value of a business can vary widely for different people in a transaction. In addition, economic conditions affect the value of a business – an increased number of interested buyers in an orderly market should result in higher selling prices.
There are generally three business valuation approaches – Asset Approach; Market Approach; and Income Approach.
The asset approach values a business taking into account its assets and liabilities. It is based on the concept of “the cost of setting up a similar business”. The assets and liabilities should therefore be valued at its fair (or market) value.
The main difficulty faced in the asset approach lies in determining the fair valuation of the business assets and liabilities. It must be noted that assets of the business include both tangible and intangible assets. Intangible assets include internally-developed proprietary products and processes. These intangible assets, which are mostly more valuable than the tangible ones, are not recorded in the books of the business.
The market approach values a business by simply taking into account “the value of other similar businesses”. This approach is based on the concept that in an ideal world, where buyers and sellers have full knowledge of all relevant facts, there should be price equilibrium. Hence, the value of a business is one where in an arms-length transaction, a willing buyer will pay, and a willing seller will accept the price for the business.
The main difficulty faced in the market approach is that businesses may be similar but they are never identical. Therefore, the market approach must take into account the differences and many a times, such differences result in significant value.
The income approach values a business by calculating or estimating the future economic benefits that can be generated by the business. This income approach concept is based on “the present value of the business based on expected income”.
The main difficulties faced in the income approach are the obvious risks of inaccurately predicting future income and subsequently using the appropriate “discount factor” to value it in today’s terms.
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