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Businesses are like Diamonds

Finding the value of a business is similar to grading diamonds. If you took a diamond and looked closely at it through its many facets, you would see different qualities each time you turned the diamond. The four Cs of diamonds are the carat, clarity, color, and cut.

A gemologist peers into a diamond and does an analysis to determine its value. Similar to looking at a diamond, you can see different value qualities in a business through the three As of valuation. These are the market approach, assets approach, and income approach.

In the market approach, the business is compared to similar companies that have already sold in the market. Like a diamond’s color is graded from colorless to yellow, the business is graded from most valuable to least valuable. Operational performance ratios, growth trends, markets and economic activity are some of the qualities considered when grading is done.

The age, condition, and value of the tangible assets are graded in the asset approach. A business with updated and maintained equipment will be graded higher than a business with outdated equipment needing repairs. Both tangible and intangible assets are considered. Contrary to popular belief, not all businesses have intangible asset value. Some people refer to this value as goodwill. When intangible value is present, the value is determined through acceptable methods.

In the income approach, the company’s net cash flows are analyzed and graded. These cash flows take into consideration the company’s need for working capital, debt (if applicable), and reinvestment needs for things like equipment. The cash flowing to the owner is evaluated as well. Included in this approach is a grading of the company’s risk. Risk has a direct impact on the rate of return used to calculate value. A high risk company will have a higher rate of return and therefore a lower value than a more stable company with a low level of risk. Assuming an “industry standard” rate of return or cap rate is applicable to a specific business guarantees an incorrect value. Businesses are not created equal and therefore each business will have its own specific rate of return.

Similar to gemologist grading diamonds, companies are graded after peering into their operations, history, markets, industry, and environment. The company’s brilliance as well as its flaws appear. Similar to examining a diamond through a microscope, it is only after a careful appraisal of the business will the value become clear.

Joseph Phelon is an accredited and certified business appraiser with Hyde Valuations. He writes on valuation and business related topics including: business appraisals, professional practice appraisals, litigation support services, and consulting services.