There are 3 basic approaches to valuing your business: the asset approach, the income approach, and the market approach.

The asset approach is based on the substitution principle. That is, it assumes that no prudent buyer/investor would pay more for a particular business than the cost of reproducing it across the street. The main flaw of the asset approach is that it does not do a good job of capturing intangible value (goodwill). The way you (and your employees) treat your customers and the reputation you have in the marketplace is not something that is easily duplicated (and therefore valued using the asset approach). Therefore, be aware of the limitations of this approach. Understand that while an asset approach provides a relative indication of value for asset-intensive businesses, it may simply serve as a liquidation value for your service-oriented business. The revenue approach and the market approach do a much better job of fairly capturing the goodwill or intangible value of your business.

The revenue approach operates under the assumption that a buyer will pay for the cash flow that their business is set to produce in the future from the date of sale. Buyers buy cash flow. How much they are willing to pay for access to your cash flow depends on the risk associated with the buyer actually receiving it once it goes out of business. If your business shows a consistent track record of steady cash flow and/or growth, a buyer is likely to pay more for your cash flow (less risk) than for the cash flow of a similar business with shaky cash that won’t can reasonably be assumed to occur again in future periods (more risk).

By valuing your company’s cash flow, you are inherently valuing EVERYTHING your company does. If your company did something different—made different decisions or operated under a different philosophy—your cash flow would look different, and your business value would look different. Your cash flow reflects all the decisions you make within your business. So I challenge you with this question, if the decisions you are making do not increase your cash flow (and buyers will pay you only for your cash flow), why are you engaging in those activities that do not result in increased cash flow? cash? ? They are not adding value to your company.

The third approach to value is the market approach. If you own a home or have rented an apartment, you have completed a Market Focus form. When you compare and contrast similar properties and then use the comparative data to value your property, you are taking a market approach. In residential real estate, you can compare things like price/square foot. or price/bedroom and price/bathroom. Once you get these ratios for similar properties, multiply the ratio by the square footage, number of bathrooms, or number of bedrooms in your home to get your property’s value.

You can do the same with companies. However, as you may have guessed, the value of your business is not determined by its square footage and bathrooms. It is driven by other metrics like revenue, assets, growth, leverage, turnover, liquidity, etc. Publicly traded companies and transactions involving other private industry participants provide an understanding of how price relates to the various financial metrics of these companies. Then, just as we did when valuing your property, we apply these market indices to your business metrics to determine your market value.

Valuation is a complex issue with many complexities that are not covered here. The purpose of this article is to familiarize you with the basic valuation approaches used. I do not recommend that you attempt to value your business without the help of a qualified expert. However, I encourage you to understand these approaches so that you can better focus on building value within your business before it’s time to sell.