Recently, we did an estimate of value (EOV) for a company, calculating that it would sell for around $8 million or $9 million in the current market. It’s a nice business and I think that number is achievable. We might even get a bit more with a strategic buyer.

The business owners were surprised, as they had a certified valuation that placed the value closer to $13.5 million. But this company has $1.5 million in EBITDA, meaning that they’d have to sell at a 10 multiple to reach that valuation target.

A 10-multiple would be highly unusual, particularly for a business of its size. So, what’s causing the discrepancy between our EOV and the certified valuation? One is formula-based, and one is market-based. There are pros and cons to each, and each method has its purpose.

Business valuations are typically based on three main methods: an income approach, and asset approach, and a market approach. As part of the income approach, valuation professionals often use the discounted cash flow formula which includes estimated future growth trends.

Unfortunately, these forecasts are subjective. Business owners, I have found, are eternally optimistic. Business is always going to get better, and sales are going to grow. The problem is, actual growth rarely keeps pace with these projections. The result is a valuation that’s higher than what the current market will actually bear.

In a market approach, we place more weight on comparable sales. We create an estimate of value based on transactions of similar companies in the industry. We also keep a pulse on the market and have confidential discussions with buyers to understand trends and buyer sentiment. The result is a valuation more in line with market realities.

It’s not that the formula-based valuations are wrong, but it’s not always the right tool for mergers and acquisitions. When you run a discounted cash flow method and project strong growth trends, a formula valuation will often indicate a business value that is not sustainable in today’s marketplace.

On the surface, a valuation might seem relatively simple. You can run a rule-of-thumb multiple against EBITDA or discretionary earnings and calculate a ballpark value. But there’s a lot more that goes into a market-based valuation. A market valuation goes beyond the financials to identify where certain value drivers, like customer diversification, intellectual property or management bench strength, would impact current value.

Each valuation approach can be appropriate, depending on the purpose, the industry, and certain business characteristics. Look for an expert with experience and industry credentials then make sure your valuation provider understands your business, and your goals, so they can evaluate it properly.