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F E E L A T H O M E www.azindiatimes.com PAGE - 21 Apr 2019 1-844-AZINDIA How to value a business? By Sat Parashar, PhD parashar.sat@gmail.com In the last three issues of AZIndia Times, we published articles con- cerning doing business in USA. January Issue discussed, why do business? February Issue discussed which business should you go for? Should you buy an existing business, franchise or build from scratch? In March, 2019 Issue, we discussed where to locate your business? Let’s now discuss how to value a business? Business valuation concerns, both, buyer and seller of a business. Buyer would like to pay the minimum price s/he can and the seller would like to receive the maximum price s/he can. The best meeting point for buyer and seller therefore has to be a fair price; a price that is fair to, both, buyer and seller. A price at which none feels overcharged or shortchanged. Price is not Value Price is the amount of money or its equivalent sacrificed in exchange for a busi- ness. It is a function of demand and supply at the time of the transaction. The price may be same or more or less than the value. The value of a business, like any other asset, is a function of DUST, where D stands for Demand; U stands for Utility ; S stands for Scarcity ; and T stands for Transferability. Businesses which are high in demand, having higher utility, highly scarce and easily transferable tend to be more valuable than businesses low in demand, having low utility, eas- ily available and cumbersome to transfer. Further, value of a business may be estimated as strategic value or financial value. Strategic Vs Financial Value Strategic value is the value of a business bought and sold for strategic (portfolio) gains, while financial value is the value of a business (standalone) traded in an arms-length transaction between two knowledgeable parties. We shall discuss here approaches to financial valuation of a business as strategic valuation de- mands fairly specific information. Three Approaches To value a business, there are three approaches, namely, cost approach, Income approach and market approach . The cost approach essentially involves determining value of a business based on replacement cost of business. This approach is fairly easy to implement and reli- able for valuing businesses with newer assets. The Income approach essentially involves determining value of a business as the capitalized value of the income estimated to be generated by that business. The capitalized value of a business can be readily calculated by dividing estimated income by a cap rate. The cap rate is nothing but the required rate of return. To make it easily intelligible, let’s put some numbers on it. If we estimate that a business is highly likely to continue generating, year after year, an income of $100,000 annually, and our required rate of return or say cap rate is 10%, the capitalized value or simply value of this business would be $1,000,000, that is 100,000/ 10% or say, 100,000/ 0.1. If you believe that the estimated annual income from this business, year after year, will not be constant $100,000 but variable; in that case a more complicated computational method like Net Present Value (NPV) or Internal Rate of Return (IRR) will be more appropriate. Those interested in knowing more about NPV and IRR may see any standard text book of finance or try google or get in touch with us. It is also pertinent to note that income of an owner-operated business, for valua- tion purposes, should be computed as Seller’s Discretionary Earnings (SDE) and not conventional accrual accounting based income, as business owners sometime pass through certain discretionary expenses. In case of manager managed busi- nesses, Earnings Before Interest, Taxes, Depreciation and Amortization (EBIT- DA) would work as a good measure of business income for business valuation purposes. The market approach essentially determines value of a business with reference to value of similar businesses actually sold and listed in the market. It is also known as Market Comparison or Market Comps approach. Market approach gen- erally uses a multiple of revenue or operating cash flow, as commonly observed in the market for similar businesses, in similar territories, to determine price. Rent multiple in multifamily, revenue multiple in hotel industry, and net cash flow multiple in services are the common examples. In any business involving real es- tate investment, floor plan, views, curb appeal, ingress and egress are unique and non-substitutable and thus put limit on application of market approach, without making necessary adjustments. Best Approach It is often stated that all three approaches are appropriate to specific situations. The cost approach, as earlier said, is appropriate for valuing newer businesses. The Income approach is appropriate for net income generating or say profit mak- ing businesses. The market comps approach is good where substitutable or com- parable businesses are being valued. In my opinion, income approach should be the primary approach. The other two approaches may be used as countercheck- ing approaches. Now, you may go value and buy a business for a fair price. There are appraisers and business brokers also who may help you in this.