Valuing a business can be done using a variety of methods, such as the income approach, the market approach, and the asset-based approach.
The income approach involves estimating the business’s future economic benefits, such as cash flow or earnings, and discounting them back to their present value. This method is useful for businesses that have a steady stream of income.
The market approach involves comparing the business to similar businesses that have recently been sold. This method is useful for businesses that operate in a specific niche or market.
The asset-based approach involves valuing the business based on its tangible assets, such as equipment and inventory. This method is useful for businesses that have significant physical assets.
Ultimately, the best approach will depend on the specific circumstances of the business and the information available. It’s advisable to consult with a business broker or a professional appraiser for a more accurate valuation.
The income approach
The income approach involves estimating the future economic benefits of a business, such as cash flow or earnings, and discounting them back to their present value.
To value a photography business using this approach, you would need to estimate the business’s future cash flow or earnings. This can be done by analyzing historical financial statements and making projections for future years.
Once you have estimated the future cash flow or earnings, you would need to discount them back to their present value using a discount rate that reflects the risk associated with the business. The discount rate is usually determined by considering factors such as the overall economic environment, the industry, and the business’s specific risk profile.
It’s important to note that the income approach is most useful when a business has a steady stream of income and predictable cash flow, otherwise, the projection would be uncertain and might not reflect the real value of the business.
When valuing a business using the income approach, the typical practice is to estimate the business’s future cash flow or earnings for a period of five to ten years. This allows for a reasonable projection of the business’s future performance while also taking into account any expected changes in the market or industry.
To discount the future cash flow or earnings back to their present value, you can use a discount rate that reflects the risk associated with the business. The discount rate is typically determined by considering factors such as the overall economic environment, the industry, and the business’s specific risk profile.
Capital Asset Pricing Model (CAPM)
One common method for determining the discount rate is to use the Capital Asset Pricing Model (CAPM), which calculates the expected return on an investment based on the risk-free rate, the market risk premium, and the specific risk of the investment. In the case of a small business business, the specific risk might include factors such as the level of competition in the industry, the business’s market position, the quality of its management team, and the overall economic environment.
Assume that a small business has the following financial data:
- Net income: $100,000
- Growth rate: 5%
- Discount rate: 10%
Using the income approach, we can estimate the present value of the business’s future cash flow by projecting the business’s net income for five years and then discounting it back to its present value using the discount rate.
The calculation would look like this:
Year 1: $100,000
Year 2: $105,000 (5% growth)
Year 3: $110,250 (5% growth)
Year 4: $115,761.25 (5% growth)
Year 5: $121,550.31 (5% growth)
Total present value: $453,461.56
This is just an example and the real value of the photography business depends on many factors such as the business’s reputation, the quality of its services, the level of competition in the market, and the overall economic environment.
Weighted average cost of capital (WACC) approach
Another method is to use the weighted average cost of capital (WACC) which is the average after-tax cost of a company’s various capital sources and any long-term debt.
Here’s an example of how you might use the WACC method to value a business:
Assume the following information:
- Market value of equity: $500,000
- Market value of debt: $200,000
- Cost of equity: 12%
- Cost of debt: 8%
- Tax rate: 30%
To calculate the WACC, you would first need to calculate the weight of each capital source. In this case, the weight of equity would be (500,000 / (500,000 + 200,000)) = 0.71 and the weight of debt would be (200,000 / (500,000 + 200,000)) = 0.29.
Next, you would need to calculate the after-tax cost of debt. In this case, the after-tax cost of debt would be 8% x (1 – 30%) = 5.6%.
Finally, you would calculate the WACC by multiplying the weight of each capital source by its respective cost and then adding them together:
WACC = (0.71 x 12%) + (0.29 x 5.6%) = 8.52%
Once you have calculated the WACC, you can use it to discount the future cash flows of the business to their present value.
It’s important to note that this is just an example, and the real value of the business depends on many factors such as the business’s reputation, the quality of its services, the level of competition in the market, and the overall economic environment.
The market approach
The market approach is a method of valuing a business that involves comparing the business to similar businesses that have recently been sold. This method can be useful for small businesses that operate in a specific niche or market.
There are several sources where you can find information on prices of businesses that have recently been sold. Some popular sources include:
- Business Brokers: Business brokers are professionals who specialize in buying and selling businesses. They have access to information on businesses that have recently been sold and can provide you with valuable insights on prices and market trends.
- Business Valuation Firms: Business valuation firms often have access to a large database of comparable transactions and can provide you with information on prices of businesses that have recently been sold.
- Online Business Marketplaces: There are several online marketplaces that specialize in buying and selling businesses, such as BizBuySell, BizQuest, and BusinessesForSale.com. These websites often have information on businesses that have recently been sold and can provide you with an idea of prices in the market.
- Public Records: Some jurisdictions make information on business sales available in public records. You can check with the county or state records office for information on business sales in your area.
It’s important to keep in mind that not all business sales are publicly disclosed, and it can be difficult to find detailed information on specific transactions, especially for small businesses. Additionally, the information may not be always accurate or up to date, so it’s advisable to consult with a business broker or a professional appraiser for a more accurate valuation.
Here’s an example of how you might use the market approach to value a small business:
Assume that you have identified three similar businesses that have recently been sold:
- Business A: Sold for $150,000 with revenue of $200,000 and net income of $50,000
- Business B: Sold for $250,000 with revenue of $300,000 and net income of $75,000
- Business C: Sold for $300,000 with revenue of $400,000 and net income of $100,000
You can use these comparable transactions to estimate the value of the small photography business. The most common method is to use a multiple of revenue or net income to estimate the value of the business.
For example, if you calculate the average multiple of revenue for the three comparable transactions, you would get: ($150,000 + $250,000 + $300,000) / ($200,000 + $300,000 + $400,000) = $700,000 / $1,000,000 = 0.7
If you estimate that the small photography business has revenue of $200,000, then the estimated value of the business using the market approach would be $200,000 x 0.7 = $140,000
Alternatively, you could calculate the average multiple of net income for the three comparable transactions, and use that multiple to estimate the value of the business.
It’s important to note that this is just an example, and the real value of the small business depends on many factors such as the business’s reputation, the quality of its services, the level of competition in the market, and the overall economic environment.
if you’re not familiar with the financials of the business and the industry standards, it is advisable to consult with a business broker or a professional appraiser for a more accurate valuation.
The asset-based approach
The asset-based approach is a method of valuing a business that involves assessing the value of the business’s tangible assets, such as equipment and inventory.
Here’s an example of how you might use the asset-based approach to value a small business:
- Equipment: The first step is to determine the value of the photography equipment. For photography business, for example, equipment includes cameras, lenses, lighting equipment, and editing software. You can research the current market value of the equipment by looking at websites like B&H, Adorama, or Amazon.
- Inventory: The second step is to determine the value of any inventory the business holds. This may include items such as prints, frames, albums, and other finished products that have been produced but not yet sold. The value of the inventory should be based on the cost of the goods, not their selling price.
- Real Estate: If the small photography business owns the property it operates in, you’ll need to include the value of the real estate. You can get an estimate of the property value by looking at comparable sales in the area or consulting a real estate appraiser.
- Other Assets: The small photography business may have other assets such as vehicles, furniture, and office equipment that should be included in the valuation.
- Subtracting Liabilities: Once the value of the assets has been determined, you should subtract any outstanding liabilities such as mortgages, loans, and leases to arrive at the net asset value of the business.
It’s important to note that this is just an example, and the real value of the small business depends on many factors such as the business’s reputation, the quality of its services, the level of competition in the market, and the overall economic environment. Additionally, the asset-based approach may not take into account the business’s earning potential, and as such it is not the most accurate method to value a business. It’s advisable to consult with a business broker or a professional appraiser for a more accurate valuation, especially if you’re not familiar with the financials of the business and the industry standards.
