Determining the Value of a Business

The process used for determining the value of a business is fairly complex and consists of many moving parts. For most operating businesses, the value of the business is based on the economic benefits that it provides its owners and the risk that the owners have in receiving those economic benefits.  Economic benefits are generally in the form of normal, ongoing cash flow (CF) that the business generates.  The risk of receiving the economic benefits is measured by the stability and predictability of the earnings and is usually expressed as a required rate of return (K).

The required rate of return can be determined by researching a variety of sources to determine what other investors are willing to pay for the economic benefits.  These sources include rates of return data from the public marketplace, rates of return surveys of market participants, and an analysis of rates of return data present in transactions involving similar businesses.
 
For most operating businesses, the value equation is simply dividing the expected normal, ongoing cash flow by the required rate of return.  For example, if the business is expected to generate $200,000 in annual cash flow in the future and the required rate of return is 20%, then the value of the operating assets of the business is $1,000,000.

The value equation (V) in its simplest form is:

V = CF
       K

The previous discussion is a simplistic view of the determination of value.  In reality, the process of determining the value of a business consists of a series of interrelated, interdependent analyses.  But a simplistic equation like the one presented above captures the essence of the determination of value of a given asset such as stock in a closely held company.