Value is based on expectations about the future

- The value of a business is based on how well you think that business will perform in the future. As I frequently say in my business school classes, when you buy a business, you are buying it's future, not it's past, and because you are buying the future, you should be surprised that business valuation is not an exact science. None of us can forecast a future perfectly, so none of us can value a business perfectly. If business valuation is about the future, then why do we often use valuation with accounting numbers, which are based on the past? Well, past accounting numbers are useful to the extent that they provide a starting point for forecast in the future. It will be relatively easy to forecast a future for a company that has a long and stable history, it will relatively difficult to forecast a future with a company with a volatile history, or no history at all. So we will naturally have more confidence in some business valuations than in others. When estimating a numerical value for a business, its value, a standard assumption is that a hypothetical sale from a buyer to a seller will be an orderly sell, not a forced sale, a hasty sale, or a fire sale. We know that in a crisis situation, a person might sell a car or a house or a business at an artificially low price because that person needs cash quickly, or has a time deadline for closing the transaction. These fire sale prices are not good estimates of the value of an asset. Also when estimating a numerical value of a business, an additional assumption is that the seller and the buyer are informed about the details of that business, and that the seller and the buyer are unrelated. For example, let's say I have proposed selling a small trucking business to my brother, Jim, or 100,000 dollars. That 100,000 dollar price is not a good reflection of the value of the business. First of all, my brother, Jim, doesn't know anything about the trucking business, so he doesn't have the information necessary to negotiate a fair purchase price. Any reliable value is one that would be aggressively negotiated between an informed buyer and an informed seller. Second of all, my mother would expect me to give my brother a good deal, so a related party price does not reflect what a business is really worth. Those are some general appraisal or valuation concepts. In the field of asset appraisal, there are three primary asset valuation techniques: the market approach, the income approach and the cost approach. We'll discuss these three approaches in detail.