If you have ever considered buying a business or selling one, you may wonder what it would be worth. There are many ways to determine value. You can evaluate the assets. You can evaluate the cash flow. You can evaluate the potential. Unfortunately, every method involves some opinion and may not be accurate for the involved purposes.
When a business is valued on its assets, the concept seems pretty simple. How much is the 'stuff' worth? Good start. Unfortunately, the value of the assets may be different that what is on the business balance sheet. Depreciation is recorded. This means that the asset is shown as being worth less than it was. Sometimes it is a tax benefit to do so. The equipment ages and each year of age can be counted as a deduction for the business. It might not be entirely true. The equipment, after a few years, may depreciate to zero value. It could still have value, however. So for valuation purposes, assets are worth their "book value" or their "market value". Usually the market value is less. This must be considered during the valuation process.
Cash flow is another determination of value for a business. Obviously, a business that earns $10,000 a month is worth more than another that generates $5,000 a month. But is the better business worth double? Perhaps the lesser business had a bad month. Over time, it might make more than the other. When determining value based on cash flow, you have to take into account the normal, average, peak and other earnings variables. It can be hard to look at an individual month and make reasonable estimates of future earnings. For valuation purposes, historical earnings are worth less than future earnings. That said, only the historical earnings are really known. The future potential can be estimated, perhaps accurately, but it isn't a sure thing.
Goodwill is an asset that many businesses track. This is similar to cash flow. Historical goodwill can be understood but future value is not. This really represents the potential for the company to have loyal customers. It is hard to quantify and even harder to value. As a business seller, the goodwill is a key selling point and must be valued highly. As a buyer, this is not really true. The goodwill could evaporate. The loyal customers could leave when the previous owner does. A new store could open up, taking customers. Goodwill is at risk so buyers value it lower than sellers.
Other items that are sold, like houses, cars or antiques, have comparable sales that can be evaluated. One particular car might be worth about the same as another that sold recently. You can adjust a little bit for any material differences, like damage, condition, etc.
In the end, the valuation of a business is not an exact science. The value of the assets are one component. Cash flow and earning potential are more valuation points. Goodwill, as explained, is very hard to use in valuation. All of these variables are unfortunate. As businesses mature and owner/operators wish to move on to other work or to retire, it is natural for them to want to sell their businesses. This is a difficult task. In the end, the value comes down to a reasonable estimate of worth that is agreed to by the buyer and seller.