At some point most business owners require an independent valuation of either the shares or assets of their businesses. The reasons for needing a valuation are varied:

• purchase, sale, or merger of a business;
• reorganization or amalgamation done for tax purposes;
• bringing key employees into ownership;
• buy/sell agreements, resolution of shareholder disputes;
• equitable division of inheritance property;
• corporate finance, e.g., lender security, raising equity funds, etc.

In some industries, there are so-called “rules of thumb “ or guidelines that are generally accepted as value determinations. For example, insurance agencies are sometimes sold for a multiple of annual commissions. Business valuators tend to use these rules only as a secondary indicator of value, since each business (even within industries) is different, with
often distinctive revenue and expense characteristics.

Business valuators tend to use future cash flow approaches to measure value. Fundamentally, the value of a business lies in its ability to generate profits
in the future. Using a company’s track record of earnings, valuators derive an expected level of cash flow for the company. The value is determined using a capitalization factor that takes into account market risks and the annual desired return.

Market transactions involving similar businesses often provide meaningful information on expected rates of return, and, more importantly, what post-transaction additional earnings (i.e., synergy, economies of scale) that purchasers will pay for.

Well established businesses with a history of strong earnings and good market share might often trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalization rates, say 25% to 50%.

In some cases, valuators will use asset-based approaches as their best estimate of value because the business has not been able to generate sufficient profits for an investor to earn the expected rate of return.

Asset-based approaches can be done on a going concern basis, or on a liquidation basis.

The issue of business valuations has increased in complexity just as the complexity of modern business has increased. Judgment calls with respect to expected earnings and rates of return are not done in isolation. The valuator must review the operations (financial, production, and marketing) of the business and consider the industry and the general
economy when determining the value of a business.