Valuing a Business – Cash Flow Based MethodsDecember 17, 2018
This approach views the business as a set of assets and liabilities that are used as building blocks to construct or substantiate the value of the business.
The economic principle of substitution applies i.e.
What will it cost to create another business like this one that will produce the same economic benefits for its owners?
Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets and liabilities, with the premium difference being the business value.
Sounds simple enough, but the challenge is in the detail: figuring out what assets and liabilities to include in the valuation, choosing a standard of measuring their value, and then actually determining what each asset and liability is worth.
As an example, many business balance sheets may not include the most important business assets such as internally developed products and proprietary established ways of doing business. If the business owner did not pay for them, the associated value/s are often not recorded in the balance sheets.
More significantly, the real value of such assets may be far greater than all the “recorded” assets combined. Imagine a business without its special products or services that make it unique and bring customers in the door. The key to using this valuation method is to identify these assets and to ensure the value/s can be substantiated for recognition as assets in the balance sheet.
Note though, the challenge with this method is that asset-based valuations can over-simplify the process and neglect the value of the company’s earnings potential. That is why asset-based valuation is a common method for the sale of defunct businesses and liquidations, but not as common for thriving companies.