Valuation methods

Simplified, the asset approach equals the value of the company´s normalized assets negative the company´s debts. Assets such as expensive equipment, heavy machinery etc, is typically depreciated faster in the books, as compared to the actual depreciation in market value. The company´s debts can also be normalized if needed, but it is rare.

The asset approach, in its simplest form, is a very simple and easy way of valuing a company. All the “actual work” within the asset approach, is the normalization.

Using the asset approach will only result in a somewhat accurate value, if the company has lots of expensive equipment, and is not profitable. The asset approach will also show a somewhat accurate value for companies that are so called “one man shows”, which in plain English means someone self employed, without patents or digital platforms etc, it is basically just one person working in the business without any transferable value.

The liquidation valuation method is a sub category to the asset approach. Sometimes you can keep the definition of asset approach and apply a discount for lack of marketability.

In plain English, the difference can be described as you sending off all the equipment to be auctioned off, as compared to the market value of said equipment.

The income approach is one of the most commonly used methods within business valuation. There are 4 main things to consider when using the income approach.

1, Normalization of the P&Ls from the last 3-5 years. The most common normalization is done to the salary of the owner or owners. It is common that business owners work 70h a week, and take out less salary then their market rate as CEOs. Other business owners don´t work at all, but still take a healthy salary, mostly because they can. Both of these, need to be normalized for.

2, The weighting between different fiscal years. Which year or years should be considered as representative and why? Oftentimes, the most reasonable is to spread it out between several fiscal years with different weighting.

3, Choice of multiple.

“One man shows” typically receive a multiple between 1 and 3.

Business that are above “one man shows” but under the size where they get attention from private equity firms, typically receive multiple 3 without assets included. If the assets are included they typically receive a multiple between 3-5.

When you reach the size where you get attention from private equity firms, the multiple is usually in the 4-7 range, but it varies heavily. Companies that are technologically advanced receive much higher multiples.

4, The definition of the multiple.

SDE stands for Seller´s Discretionary Earnings. In plain English, it is profit and owner salary combined.

EBITDA stand for Earnings Before Interest Taxes Depreciation and Amortization. In plain English, it is somewhat similar to a gross profit.

Normalized net profit is the only thing that one really should consider.

Discounted Cash Flow is a sub category to the asset approach. Simplified, the DCF uses a calculated interest rate, and calculates the return on the investment over time. The interest becomes relevant because money today is more worth than money tomorrow. This valuation method is mostly suitable for startups.

A few things to consider:

A, Cash flow and accounting profit differ. Cash flow is literally what it sounds like, the cash flow, which does not take into account amortization etc. Accounting profit is also what it sounds like, which is typically a much better way to measure profitability, but only when the company is not distressed and when it is properly normalized or audited.

B, A cash flow valuation and discounted cash flow differ, with the difference being the applied interest rate, in the discount cash flow valuation.

Banks are typically primarily interested in cash flow, but you as the owner of the business should be more interested in normalized accounting profit.

The market approach is common when the business in question only owns commercial property, then it is more of a commercial property valuation, than a business valuation.

The market approach is also common to apply when the business that is being valued is in an industry where transaction are very frequent, like restaurants and bars etc. The market approach is not suitable for most other industries, and is therefore not applied to most other industries.

Nielsen Valuation Group only employes the market approach, when there is enough reliable data of other transactions. In the real world, there is often a lack of data, for the market approach to be used alone, without the combination of other approaches. Ones good way to employ the asset approach in combination with the income apporach, is to use the same multiple as other comparable transactions.