Value is a delightfully common word, but it is used in so many different ways that it sits somewhere between vague and meaningless. In a customer-centric sense, it deals with what the customer receives. We talk of value-adding, for instance. Porter’s value chain deals with how a firm creates that value.  We talk of the values a person or company has. We also use it to mean important: as in what do you truly value?

I generally talk about value in quite a technical way, drawing on its economic meaning of worth. Specifically, what something is worth in a transaction – to buy or sell. And in almost every case, the principal measure of value is dollars (or your local currency). More precisely, the type of value I am generally considering is business value, what a business, or sometimes a part of a business, is worth. In dollars.

There is a huge array of factors that drive the value of a business. In many cases, business owners only consider these factors if they are looking to buy or sell a business, but I believe they are factors all business owners should be thinking about as they run their business, not just when they are looking to exit.

Value is a delightfully common word, but it is used in so many different ways that it sits somewhere between vague and meaningless. In a customer-centric sense, it deals with what the customer receives. We talk of value-adding, for instance. Porter’s value chain deals with how a firm creates that value.  We talk about the values a person or company has. We also use it to mean important: as in, what do you truly value?

I talk about value in quite a technical way, drawing on its economic meaning of worth. Specifically what something is worth in a transaction. And in almost every case, the principal measure of value is dollars.

There is a huge array of factors that drive the value of a company. In many cases business owners only consider these factors if they are looking to buy or sell a business, but arguably they are factors all business owners should be thinking about as they manage their business.

Determining the value of a business is like developing a prophecy for the future. This concept is really important. The value of a thing – a car, a business, artwork, anything – is not in its history but in its future. As the owner, what will I earn from this thing in the future?

Valuation: Art or Science?

Assessing and assigning a value to something is the essence of valuation. There are three basic methods we can employ to determine the value of something. The most natural is to find data on recent sales of other, comparable things that best resemble the features of our thing. This approach includes looking at the price of similar things for sale. This method is called the market approach.

The asset-based approach considers the value of something by evaluating the components that make up the thing. The item is the sum of its parts. In business terms, this method looks at the assets owned – both tangible and intangible – less the liabilities (what is owed). Finally, the income approach sums up the future earnings (e.g., profits) I will receive as owner of the thing to determine value, discounted to today’s value.

All of these approaches have a range of complexities in practice and inevitably rely on the subjective experience of the person performing the valuation. The market approach relies on the availability of comparable data and the actual definition of comparable. When using the asset-based approach, it is necessary to consider how a value is placed on each of the constituent parts. Replacement value? Depreciated (used) value? What if a part is obsolete? What if the whole item is obsolete? In the income approach, how are those future streams of profit determined? What interest rate should be used to discount the cash flow to calculate the current value?

Within each approach are typically a range of actual methods. Comparable business valuation data, for instance, might come from the share market or from the sale of private firms, and be based on comparing the revenues or profits of these firms.

In many cases, there is often a fourth method, collectively referred to as ‘Rules of Thumb.’ This is a calculation based on observable data about the thing and some multiplier developed through experience. For instance, the value of a cafe might be estimated by multiplying the average volume of coffee beans used (in kg) in a week by 18. Why 18? Well, that came from experience, generally developed over time by noting the correlation of prices actually achieved at sale with the benchmark metric (in this case, kilograms of coffee beans). Rules of Thumb are ‘quick and dirty’ calculations that can give an order-of-magnitude approximation of value, but are rarely used as the sole method.

As many of these approaches and methods as possible – for which there is reliable data – should be used simultaneously, and then ‘triangulated’ to use the most reliable results and to finalise the valuation. Triangulation is another subjective process that essentially weights the various results based on perceived accuracy. It is all more art than science.

There are myriad other factors I need to consider when undertaking a business valuation. This is a general starting point, but there is much more to it than I have provided here. This is where the science – the rigor – gets overlaid. We’ll discuss some of those aspects in subsequent articles.