What’s a comps valuation? Basically, a comps valuation is a process for determine the worth of a business. Sometimes, a small business comps valuation is used for determining the selling price of a business that will continue to operate under new leadership. Sometimes, comps valuation is used to determine how much of the business’s debt can be satisfied if the assets are liquidated in bankruptcy. Sometimes comps valuation is useful for determining the stock value when raising capital in exchange for equity in the business.
Just as the purpose for business valuation analysis varies broadly, so does the method used to calculate the final number. Stay tuned for our overview of valuation approaches.
Three Valuation Approaches
- Asset Approach
The asset approach is generally used to determine how much money the business could collect if it sold every asset it had, and paid off any liabilities it had. The business could be capable of earning a trillion zillion dollars, or it could be capable of earning one dollar. The amount of money it could generate does not matter.
As you can imagine, the asset approach is most commonly valuable when a business is no longer operating, and the assets are needing to be liquidated. You’d think this approach is the most straight forward for calculating, since most liabilities are hard and fast numbers that don’t require any assumptions, and the market value of the assets should be difficult to determine. However, an asset is only worth what someone is actually willing to pay for it. Factors such as the condition of the asset and the demand for it, make the number hard to pin down. Some assets, such as knowledge and “sweat equity,” are hard to put a number on.
- Market Approach
The market approach considers what other, similar businesses are valued at. This is a valuable approach if the business is just getting going and doesn’t have historical performance numbers to show their income. Every business it’s slightly different, but the industry and size of the business somewhat determines what the value of the business is worth.
For example, let’s say you’re interested in purchasing a shoe store franchise. Maybe the shoe store you’re looking at hasn’t been around long enough to show their income reliability. The asset valuation isn’t incredibly useful here, because they could have a warehouse full of product, it’s not a huge indication of how much they could make in the future. However, if you look at the value of other shoe stores of the same size, in the same area, you could get an idea of what the “going rate” of a shoe store is.
The market approach is not without flaws. If the business you’re interested in going into doesn’t have any equivalent counterparts to be compared to, there’s no market data to compare it to. Also, as mentioned, every business is unique. Sometimes the intangible assets, such as great leadership, are what gives one business success and another one none, within the same industry. Sometimes, the market value can be skewed since the reported valuation of a business is not necessarily how much someone would actually pay for it.
- Income Approach
As the name suggests, the income approach is a representation of how much money the business can bring in. Let’s say a business had to take a huge loan out in order to get their operation going. Using the asset approach, the business might have a valuation of nil. Maybe it’s a unique business that doesn’t have any similar businesses to be compared to, or maybe its ability to generate income is far better than other similar businesses. You wouldn’t be able to use the market approach to accurately determine the value of the business. In this case, considering the earning power of the business is a good way to determine value.
With the income approach, the risk is in the fact future earnings have to be estimated. Let’s say that it is the owner of the business who is the fuel that keeps their earning power high. If the ownership changes (the whole point of the valuation), it’s possible that the earning power might change. To reduce the risk, many business valuations actually utilize all three of this approaches.