Every business valuation report, no matter how thick, rests on three basic approaches: income, market, and asset based. The appraiser usually runs more than one, compares the results, and picks or blends a final number. If you understand these three ideas, you can follow almost any valuation report.
This is the second post in our series on business valuation in a Washington divorce. Here we’ll use the same made up company from the first post, Evergreen Plumbing: six vans, ten employees, about $200,000 a year in cash flow after paying the owner a market salary, and $350,000 in net tangible assets.
The income approach
The income approach says a business is worth the future income it can produce. It’s usually the centerpiece of a divorce valuation for any profitable company. There are two main methods.
Capitalization of earnings. The appraiser picks a single sustainable annual cash flow number and divides it by a capitalization rate. The cap rate is the investor’s required rate of return minus the expected long term growth rate. Think of it as a risk dial. Riskier business, higher rate, lower value.
For Evergreen: $200,000 of cash flow divided by a 15% cap rate is about $1,333,000. Divide by 20% instead and you get $1,000,000. Same company, same cash flow, and a five point change in the rate moved the value by a third of a million dollars. That’s why the cap rate gets so much attention at trial.
Discounted cash flow (DCF). Instead of one number, the appraiser forecasts cash flow year by year, then discounts each year back to present value. DCF shows up more with growing companies or ones expecting big changes. It relies on projections, and projections are only as good as the assumptions behind them.
Either way, the income being measured isn’t the profit on the tax return. Appraisers work toward net cash flow: after tax earnings, plus non-cash deductions like depreciation, minus the money the company must reinvest in equipment and working capital to keep going. A number that skips those last subtractions looks like cash flow but overstates what an owner can actually take home. Watch for that.
The market approach
The market approach values the company by comparison, the way a real estate appraiser uses comparable sales. The appraiser finds sales of similar businesses in transaction databases, computes multiples from those deals (price to revenue, price to earnings), and applies the multiples to the subject company.
Say the database shows small plumbing companies selling at a median of 0.6 times revenue. Evergreen does $1.6 million in revenue, so that suggests roughly $960,000. Another multiple, say 2.5 times seller’s discretionary earnings, might suggest a different number.
The market approach sounds objective, but it has real limits with small businesses:
- The comps are thin. “Plumbing contractors” in a database can range from one van operations to regional outfits. The classification may not match your company at all.
- The deal terms are unknown. Databases usually don’t show whether the seller financed the sale, stayed on for a year, signed a noncompete, or sold the real estate too. All of that affects price.
- The multiples spread widely. A “median” hides the fact that half the deals were higher and half were lower, sometimes by a lot.
Appraisers know this, and reports often admit the market data is rough, then use it anyway as a reasonableness check on the income approach. That’s fair, as long as everyone remembers which number is driving the conclusion.
The asset approach
The asset based approach values the business as its assets minus its liabilities, with everything restated to current value rather than the accounting numbers on the balance sheet. The appraiser values trucks at what they’d bring today, not their depreciated book value, and tests receivables for collectability.
For Evergreen, that’s the $350,000 figure. The asset approach usually sets the floor for a profitable company, because it ignores goodwill. It matters most for holding companies, businesses that own real estate or equipment but earn little, and companies that are winding down.
There’s also a hybrid called the excess earnings method. It values the tangible assets, figures out how much income those assets alone should produce, and treats any earnings above that as coming from goodwill. The appraiser capitalizes those “excess earnings” into an intangible value and adds it to the tangible assets. It’s an old method, borrowed from a Prohibition era tax ruling, and it’s error prone, but courts still see it in divorce cases, especially for professional practices.
How the approaches fit together
A careful appraiser runs the approaches that fit the company, then reconciles them. For Evergreen, the income approach said roughly $1.3 million, the market approach roughly $1 million, and the asset approach $350,000. The appraiser might conclude the income approach deserves the most weight because the company’s value is its earning power, land on something like $1.2 million, and explain why.
Two things to check in any report. First, which approach actually drives the number. A report may describe all three but rest 100% of its weight on one. Second, whether the approaches agree with each other. If the income approach says $1.3 million and comparable companies sell for half that, the report should explain the gap, not ignore it.
Why two honest experts still disagree
Notice that nothing in these three approaches is automatic. The cap rate, the “sustainable” cash flow, the choice of comps, the weighting between approaches: each is a professional judgment. Two credentialed appraisers can follow the same textbook and land hundreds of thousands of dollars apart. The next post walks through exactly which judgment calls move the number most, and in which direction.
If you’re heading into a divorce where a business needs a valuation, we can help you understand what the number should look like before the experts get locked in. Call us at (425) 954-5578 or schedule a consultation.
This post is part of our series on business valuation in divorce. Start with the first post, How a Business Valuation Works in a Washington Divorce. The next posts cover the judgment calls behind the numbers and how to read a valuation report.
This article is general information, not legal advice. Every case is different. If you’re facing a divorce involving a business, talk to an attorney.
