By Joseph Phelon
Copyright
(c) 2010
http://www.superiorvaluations.com
Finding
the value of a business is similar to grading diamonds. If you took a diamond
and looked closely at it through its many facets, you would see different qualities
each time you turned the diamond. The four Cs of diamonds are the carat, clarity,
color, and cut.
A gemologist peers into a diamond and does
an analysis to determine its value. Similar to looking at a diamond, you can see
different value qualities in a business through the three As of valuation. These
are the market approach, assets approach, and income approach.
In
the market approach, the company is compared to similar businesses that have previously
been sold in the market. Like a diamond's color is graded from colorless to yellow,
the business is graded from most valuable to least valuable. Operational performance
ratios, growth trends, markets and economic activity are some of the qualities
considered when grading is done.
The age, condition, and
value of the tangible assets are graded in the asset approach. A business with
updated and maintained equipment will be graded higher than a business with outdated
equipment needing repairs. Both tangible and intangible assets are considered.
Contrary to popular belief, not all businesses have intangible asset value. Some
people refer to this value as goodwill. When intangible value is present, the
value is determined through acceptable methods.
In the income
approach, the company's net cash flows are analyzed and graded. These cash flows
take into consideration the company's need for working capital, debt (if applicable),
and reinvestment needs for things like equipment. The cash flowing to the owner
is evaluated as well. Included in this approach is a grading of the company's
risk. Risk has a direct impact on the rate of return used to calculate value.
A high risk company will have a higher rate of return and therefore a lower value
than a more stable company with a low level of risk. Assuming an "industry
standard" rate of return or cap rate is applicable to a specific business
guarantees an incorrect value. Businesses are not created equal and therefore
each business will have its own specific rate of return.
Similar
to gemologist grading diamonds, companies are graded after peering into their
operations, history, markets, industry, and environment. The company's brilliance
as well as its flaws appear. Similar to examining a diamond through a microscope,
it is only after a careful appraisal of the business will the value become clear.
