For an investor looking to sell or buy a business, many factors can determine the worth of a business. And, it goes without saying, understanding the differences between value vs. price is undeniably the most potent investment tactic.
It’s usually the jumping-off point for estimating the cost of a deal and an excellent guide in negotiations. Plus, failure to distinguish such a difference may lead to the overpricing or underpricing of a business. That is, the price on offer failing to match a business’s theoretical value.
It’s reasonable enough, especially to some emerging entrepreneurs, for the valuation and price of a business to sound similar. But, value and price are two contrasting particulars.
For starters, unlike the price, there is a lot of complexity in the valuation of a business. In simple terms, price is the total payment paid to the seller by a real buying party. Still, there is more to that. However, we first have to understand what value is, factors considered when valuing a business, how to calculate the value and the connections between value and price.
Cognizance of these crucial details goes a long way in determining the outcomes of your transactions in the business realm.
First and foremost, there is book value and market value. As the name suggests, book value lies at the bottom of a firm’s balance sheet. That is, what investors would receive if they sold all the firm’s properties or assets and settled its debts and liabilities.
On the other hand, market value is the business’s worth according to the stock market. As a result, market value might be more significant (as in most cases) or less than the book value. Why? Market value tends to capture the profitability of a business, intangible assets, managerial structure, and the future growth prospect of your business. As you can expect, if a company forecasts an increase in earnings, the market value will obviously be higher than the book values.
A business valuation helps determine the worth of a business and plays a part in tax reporting.
All in all, before buying or selling a business, an appraiser considers multiple components such as the market’s reaction, the prospective buyers, and the duration in the future the company can continue its operations. Take into account that these considerations are bound to differ from how the negotiation occurs once the sale process starts. And this is what results in the dissimilarity between value vs. price.
Calculating the Value of a Business
There are a variety of business valuation methods. Whichever method you use to estimate the worth of a business, remember that it will only be worth what a prospective buyer is willing to pay for it. Therefore, it’s essential to get an accurate evaluation to avoid losing your shirt.
Typical approaches to ensure you capture an accurate valuation are:
Also referred to as cash flow, the present value of a firm’s future earnings determines the value of a business. How do you define such future earnings? An appraiser, or in this case, the involved party, forecasts the business’s profits and then remodels them for changes in growth rates, taxes, cost structure, etc. In turn, one can painlessly assess the likelihood of achieving the said cash flows.
Value service-oriented firms or businesses with intellectual property value—for example, software companies and grocery store chains find the Income-Based Approach particularly helpful.
The market approach involves observing the signs from the actual marketplace. That is, an appraiser reviews recent transactions made by other firms in relatable industries. Subsequently, since not all transactions or assets are similar, they can make various adjustments to determine what a business is worth.
This method is most useful where factual data regarding the recent sales of comparable assets or transactions are available to the public. For instance, the market approach is easy to apply in markets such as residential real estate.
In other instances, one has to use the market approach concurrently with the income-based to ascertain a valuation.
As the name implies, the value of a business depends on its assets after subtracting liabilities. Sounds familiar to what may lie at the bottom of the balance sheet (book value), right?
However, in this case, it will differ due to timing and other factors. For instance, analysts might use intangible assets not present on the balance sheet. Not to forget, the asset approach provides the liberty for using the market values instead of the balance sheet values.
Value vs. Price: What to Know When Buying or Selling a Business
Now that all cards regarding value are on the table, does it imply you can make a successful acquisition or sale with the said accurate valuation?
Well, buying and selling is a complex entity involving several moving pieces. Therefore, a lot of factors come together to move the price away from the valuation. Either higher or lower. Reasons as to why the price may not match the value include:
- Not all buyers are the same. Some buyers look for an acquisition to integrate it into their existing operation and diversify their revenues streams. Others might want to buy a business at a discount to sell it later (financial buyers). In this case, the essential strategy is to pinpoint your ideal buyer.
- The sense of urgency of the transaction.
- The number of interested buyers. As you can imagine, if several investors are interested in acquiring a particular startup, the price is likely to be higher.
- Everyone has their negotiation techniques.
The bottom line is if you are willing to buy or sell a business, understanding the difference between value vs. price gives a critical standing ground on how one is to dictate the negotiation process. You have to weigh all factors to make an astute decision.