Rules
Part of Valuation methods start from two definitions of profit, and that is where they diverge
Three families of valuation method, and what each one cannot see
Comparing valuation methods by what each family needs, what it is blind to, how the other side attacks it, and what to do when the answers disagree.
The three families of valuation method are usually compared by what they calculate. That is the least useful comparison, because the calculation is the easy part. The useful comparison is by what each family needs, what it is blind to, how the other side attacks it, and who relies on it for what.
This page runs the three across those dimensions, then deals with what actually happens: the methods disagree, and you must decide which is telling the truth.
What to take away
- Compare methods by their blind spots, not their formulas. Each family cannot see something the others can.
- Every method has a standard attack, and a valuation that has not anticipated the attack will lose to it.
- The methods are used by different parties for different purposes, and a sale of this size warrants an intermediary, an accountant and a lawyer partly because each of the three leans on a different one.
Dimension by dimension
Earnings-based
- What it measures
- The present worth of a stream of future profit
- What it needs
- Normalized earnings on a stated basis; a view of durability
- What it cannot see
- Working capital the profit consumes; the end date of any contract the profit rests on
- Who leans on it
- Buyers and lenders, above all
- The standard attack
- Challenge the adjustments and the durability, one item at a time
- The standard defense
- Every adjustment documented; evidence the earnings survive the owner
Asset-based
- What it measures
- What the business's things would fetch, less what it owes
- What it needs
- Realisable values, not book values; a complete liability list
- What it cannot see
- Customers, staff, know-how, and anything that walks
- Who leans on it
- Anyone deciding whether to wind down rather than sell
- The standard attack
- Challenge the realisable values; assets sell for less than owners think
- The standard defense
- Dealer valuations, not estimates; a liability list nobody can add to
Market comparison
- What it measures
- What buyers have actually paid for similar businesses
- What it needs
- Completed deals, similar kind and scale, recent, with terms
- What it cannot see
- Why each comparable sold for what it did
- Who leans on it
- Intermediaries and appraisers with database access
- The standard attack
- Challenge the comparability, then ask for the terms
- The standard defense
- Terms of each deal shown; a business that genuinely resembles them
Read the middle row first. What a method cannot see is the whole reason a buyer will run a different one.
Three Valuation Families Compared
Earnings-based
- What it measures
- Future profit stream
- What it needs
- Normalized earnings
- What it cannot see
- Working capital, contract end
- Who leans on it
- Buyers and lenders
- Standard attack
- Challenge adjustments
- Standard defense
- Documented adjustments
Asset-based
- What it measures
- Things less debts
- What it needs
- Realisable values
- What it cannot see
- Customers, staff, know-how
- Who leans on it
- Wind-down deciders
- Standard attack
- Challenge realisable values
- Standard defense
- Dealer valuations
Market comparison
- What it measures
- Prices paid for similar
- What it needs
- Completed similar deals
- What it cannot see
- Why comparables sold so
- Who leans on it
- Intermediaries, appraisers
- Standard attack
- Challenge comparability
- Standard defense
- Shown deal terms
The earnings family, examined
Its strength is that it values what a buyer is buying: a stream of profit that continues after closing. Its weakness is everything the stream depends on that the accounts do not show.
The formal version of this family, discounted cash flow, makes the assumptions explicit: a forecast of future cash, a rate that expresses how uncertain that cash is, and a period over which it is counted. Every simpler version makes the same three assumptions silently, which is why a buyer's first move is to ask what they were.
The valuation methods guide sets out the two definitions of earnings this family runs on and why a buyer will insist on one of them. The comparison point here is narrower: this family is the only one that directly answers the question a lender asks, which is whether the profit will service the debt.
The asset family, examined
Its strength is that it rests on things that can be inspected and sold. Its weakness is that most small businesses are worth more than their things, and the difference, the customers, the staff, the reputation, the way the work gets done, is invisible to it.
It earns its place in two situations. When the asset figure exceeds the earnings figure, it tells the owner the business may be worth more wound down than sold. Only the owner can make that call.
When a buyer finances the purchase against the assets rather than the earnings, the lender will run this method whatever the buyer believes.
The market family, examined
Its strength is evidence, not argument: buyers paid this. Its weakness is that owners rarely have that evidence, and listings and hearsay are not evidence at all.
Genuine comparables are completed deals of similar kind and scale with known terms. They sit in databases used by appraisers and intermediaries, and an intermediary's real contribution to a valuation conversation is usually data the owner cannot get, not a method.
Even with the data, the method is a check rather than an answer. A comparable tells you what a particular buyer paid for a particular business under particular pressures, and averaging comparables strips out exactly the pressures that set each price.
When the methods disagree
They usually do, and the disagreement is where the value of running more than one lies.
- Earnings figure below asset figureask whether to sell the business or its parts.
- Earnings figure above what any comparable achievedre-examine the adjustments and the durability assumption.
- Comparables above the earnings figureask what the comparable businesses had that yours does not, or whether their terms are known.
- Two earnings figures on different basesestablish which buyer you are talking to; the seller preparation year is when you decide which buyer to prepare for.
What you should not do is average the methods. Each is measuring something different, and an average of three different measurements describes nothing.
Which one the other side will use
A buyer who will run the business uses the earnings family on the owner's-benefit basis. A buyer who will install a manager uses it on the operating basis, and the gap between the two is the first argument. A lender uses the earnings family for service and the asset family for security.
An intermediary quotes the market family, with or without the data to back it. A court or a tax authority specifies its own basis, and the accountant tells you which. Knowing in advance which method the person across the table is running, and what its blind spot is, is most of being prepared for diligence on the number.
