A business consists of a group of assets, both tangible and intangible, working together to generate a future stream of profits. The value of a business depends, therefore, on its profit-making potential. Each asset within a business may have a specific disposable value if sold separately in liquidation; however, it is important to realize that business assets are held not with the intention of disposal, but in order to conduct business operations. For this reason these separate asset values usually have little impact on the valuation process. The primary method of valuing a business is the capitalization of earnings method. This method weighs the earnings potential of a business against the risk associated with those potential earnings. The value of the business is equal to the estimated future profits capitalized to yield a rate of return consistent with what is required to justify the risk. Although the calculation itself is simple, the process of estimating future profits and the rate of capitalization is not. Both these estimates are extremely subjective, and prone to wide variations among different valuators. For the sake of more accurate profit projections, and to eliminate risk, a purchaser can analyze the company's past earnings performance. However, past earnings must be substantiated, and then adjusted after a thorough appraisal of these factors: related markets, production capability, management expertise, competition, and economic and environmental influences. The speculative aspect of business valuations can be diminished if buyer and seller enter into a contingent price agreement, which establishes a base price and allows for adjustments to that price after future performance is assessed. The process of valuing businesses is an art and not a science, and requires considerable investigation and foresight.
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2003 McGraw-Hill Higher Education