Recently, I had the pleasure of sitting down with Vince Centofanti, a director in our valuation forensics and litigation support department at Brown Edwards, to discuss a topic that's crucial for many business owners but often misunderstood: business valuations.Editor's Note: This blog post is adapted from a transcript of our Manufacturing Minute podcast episode featuring Vince Centofanti, Director, Valuation Forensics and Litigation Support Department, Brown Edwards. The content reflects the conversational nature of the original recording.
What Exactly Is a Business Valuation?
A lot of people don't realize that business valuation services even exist. When most of us think about valuing a company, we might picture checking stock prices on an exchange for companies like Apple or Amazon. You can log into your investment account and see live values throughout the trading day. But what about private businesses? What about that family-owned manufacturing company or small distribution firm?
As Vince explained to me, this is exactly where business valuation professionals come in. When you own a small business, a private company, or a family business, there's no public market for your shares. There's no readily available value you can simply look up. That's what makes business valuation work so essential—it helps business owners understand what their interest in a private business is actually worth.
Why Do Businesses Need Valuations?
The reasons for getting a business valuation are surprisingly broad. During our conversation, Vince outlined several common scenarios:
Planning Purposes: Sometimes a business owner simply wants to know what their business is worth. It's a fundamental piece of information for making informed decisions about the future.
Tax Purposes: This includes gift tax planning, estate planning, and estate tax filing after a business owner passes away – sometimes even for income tax purposes.
Financial Reporting: Companies may need valuations for their financial statements.
Mergers and Acquisitions: When businesses are buying or selling, having an accurate valuation is critical.
Legal Situations: This can include marital disputes, shareholder disputes, and dissenting shareholder cases.
Despite the variety of purposes, the goal remains largely the same: to establish a defensible value for a private business or business interest.
Business Valuations vs. Real Estate Appraisals
One point of confusion Vince and I discussed is the difference between business valuations and real estate appraisals. While the terms "valuation" and "appraisal" are largely synonymous in the business world, a business appraisal is very different from a real estate appraisal.
Most people are familiar with real estate appraisals—you need one when you buy a house and get a mortgage. The bank performs an appraisal to ensure they're lending you an amount that aligns with the property's value. While a business valuation is conceptually similar, the methods and what is being valued are quite different. However, both real estate appraisers and business valuation professionals use three major approaches when determining value.
The Three Approaches to Valuing a Business
Just like real estate appraisers have standard approaches for valuing property, business valuation professionals consider three major approaches: the income approach, the market approach, and the asset approach (also called the cost approach).
The Income Approach: For Operating Businesses
The income approach is most applicable when valuing an operating company—an entity that's in business with the goal of generating ongoing annual profits and cash flow. According to Vince, there's typically value that exists above the tangible assets that the business owns.
This approach is particularly relevant for many of our manufacturing and distribution clients. Even though these businesses may be asset-intensive with significant equipment and inventory, they exist primarily to generate profit. In almost all circumstances, the income approach is the most appropriate method for these operating businesses.
The same goes for professional service firms, hospitality groups, and restaurants. These are operating businesses that exist to generate profit, making the income approach the natural choice.
How the Income Approach Works
Vince walked me through the two key inputs to the income approach formula:
Future Cash Flows: The first input is the cash flows expected to be generated in the future. Valuation professionals look at historical cash flows to establish a baseline, then make adjustments based on expectations for the future. They consider factors like expected growth rates, changes in margins, and other relevant business factors.
Risk Assessment: The second input is the risk associated with generating those cash flows. This is where it gets interesting. Several risk factors come into play:
- Size of the company (smaller companies typically carry more risk)
- Customer concentration (if 50% of revenues come from one customer, that's a significant risk)
- Management team strength (a strong management team with a CEO, CFO, COO, general manager, and contingency plans may reduce risk)
All of these considerations go into determining these two key inputs, which ultimately drive the valuation formula.
The Asset Approach: For Holding Companies
The asset approach sits on the other side of the coin. We apply this approach most typically to holding companies—whether investment holding companies, real estate companies, or even real estate operating companies.
Vince gave the example of a company that owns significant real estate with most or all of it rented out. In this case, we may apply both an income approach and an asset approach because the company is heavily capital invested, but also generating annual revenue from rental income.
When looking at a holding company that's holding assets for appreciation over time, the income approach likely isn't applicable. The value of that business comes from the value of its assets as of the valuation date, not necessarily the cash flows it's generating. If it's generating minimal cash flows or none at all, the asset approach is going to be most appropriate.
The Market Approach: Comparing to the Competition
The last approach is the market approach, which is applicable in many situations. This method attempts to compare the performance of the subject business to some other business or group of businesses in the market.
There are typically two ways to apply this approach:
Comparison to Public Companies: This involves comparing the business to similar public companies. However, as Vince pointed out, this can be challenging because many of our clients' businesses are much smaller than public companies.
Comparable Transactions: This method looks at actual sales of similar private companies in the market. The challenge here is that many private company transactions are not publicly disclosed, making it difficult to find truly comparable data.
The Complexity Behind the Numbers
What became clear to me during our discussion is that a business valuation is a complex calculation that takes significant work and careful consideration of numerous assumptions. It's not as simple as plugging numbers into a formula. It requires professional judgment, industry knowledge, and a deep understanding of the specific business being valued.
For business owners in manufacturing and distribution—which are industries we work with extensively at Brown Edwards—understanding your company's value isn't just an academic exercise. It's essential information for making smart decisions about your business's future. Understanding these approaches can help you better prepare for a valuation and understand the questions your valuation professional might ask.
Megan Meador is an audit and assurance partner at Brown Edwards, where she leads the manufacturing and distribution practice. She hosts the Manufacturing Minute podcast, featuring insights on trends and topics shaping the manufacturing world.
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