It has been reported recently that over 700,000 businesses will trade hands this year. This number is likely to climb year over year through the next decade as baby boomers pull down the signage and pick up the golf clubs. In addition to business sales, valuations are routinely done for tax and regulatory issues, loan processing and reporting to investors. Most of the transactions between businesses or private parties will go smoothly with the parties reaching agreement on an equitable valuation. And in almost all of these transactions or appraisals the value is at best an educated approximation.
Business valuation is as much art as science and in the SMB world leans strongly toward the artful appraisal. It can be complex, expensive in both time and resources and requires professionals - business valuation firms and CPAs versed in valuing a going concern. As with most professional services it adapts with experience and choice of method depends on the reason for a valuation - tax issues resolved in court, business sales, loan processing, etc. It starts with financial statements and accounting records and then involves assigning premiums or discounts appropriate to the interests of each party in the proceedings or transaction.
There are three primary ways to value a business - asset based, income approaches or market metrics and several variations each within those broader methods. Depending on circumstance one method may be preferred or at least better justified than another. It usually comes down to the skill and experience of the examiner to determine which method and data are used to arrive at value. And as might be expected, different methods will be used based on whether the evaluator was retained by the buyer or the seller, the tax court or defendant, the investor or operator, the loan officer or the debtor.
Asset based valuations
Asset based methods (book value, adjusted book value, economic balance sheet and liquidation) are common when a business's assets are put on sale or for assessing the value of holding and investment companies. These methods can be applied to just about any business situation - retail, manufacturer or service business. Book value - common equity on the balance sheet - is among the straight forward ways to arrive at a business value.
The advantage gained with simplicity is offset by the shortcomings of the method which uses historical costs and depreciation that don't reflect the current market values. The process starts with recasting the financials, adjusting for the owner’s participation, goodwill, intangible assets (IP, distribution channels, partnerships, deferred financings) and results in an adjusted book value, the minimum acceptable price for a going concern. A further refinement is to adjust tangible and intangible assets to their market value to arrive at the Economic Book Value.
Sometimes potential acquirers play what-if scenarios to arrive at a suitable price for a business. They consider the value as what it would cost to replace the assets used by a business. This will often lead to a higher value than book. Subtracting the liabilities then provides the replacement value of the business. Another shorthand method is to assess how long it would take to create a similar business and then assign a premium for getting to market sooner by acquiring rather than building a firm.
The last method is treating the value of the business as what sales of pieces of the company or sellable assets would bring at liquidation. Liquidation method will provide the lowest value of the assembled assets. This is used when going out of business but should not be a basis for establishing a sales price - though it is often used when negotiating a purchase price!
Income or earnings based valuations
Income valuations are most often used to evaluate a going concern or part of a business and the future value an investor or new owner might receive. The methods most commonly employed include the capitalization of earnings, the discounted future income, the discounted cash flow, the economic income, dividend paying ability or variations on these formulae. Capitalization and discounting formulae are methods of adjusting for present value. Many smaller businesses are evaluated with these methods as they put a premium on historical performance and usually provide a higher valuation through addition of goodwill, intangibles and performance based expectations rather than mere asset value. Buyers may be leery of using the past results to predict future prospects but these methods are generally accepted by both buyers and sellers.
Capitalization of earnings or cash flow is a common method that is used when the primary value of the company are intangibles, often the case with a service business. It starts with Earnings Before Taxes and Interest (EBIT). The ROI that is anticipated is based on a set of factors which are ranked and then the ranking becomes a multiplier on income to arrive at the business value. 25% ROI is often cited as a reasonable return on an SMB. Even where the operations of the firm are well understood, there can be significant differences in ROI based on experience of operators, existing relationships, specific expertise that is not easily quantified.
Arriving at the value of a company based on historical performance requires significant skill in the appraiser. A well known method to arrive at the intrinsic value of a business is the Discounted Cash Flow. As with the other methods this starts with recast financials which are used to forecast future free cash flow (5 years typically) - assuming no material changes in operations. The annual future revenues are then discounted for the time value of money (using the Weighted Average Cost of Capital) and summed to arrive at total Net Present Value - the terminal value a buyer should be willing to pay for a company.
The IRS often uses the excess earnings method of valuing a small business where assets and historical earnings are used to arrive at valuation in estate or gift tax cases. To arrive at excess earnings the financial statements are recast (owner's participation, non-recurring income/expenses, etc.), the income statement averaged over 3 or 5 years and balance sheet with assets marked to market. The excess earnings are arrived at by subtracting the annual earnings based on the recast financials from the actual earnings. This seeks to capture the amount of earnings due to goodwill and going concern value of the business. Dividing the excess earnings by a capitalization rate (the expected ROI for instance) provides the valuation.
Most small firms and closely held firms do not pay dividends. But the dividend capitalization method can be used to value a business based on its averages of net income and cash flow as a proxy for the ability to pay dividends. Dividends are paid out to shareholders after all the operating expenses, expansion capital, debt servicing and contractual obligations are satisfied. Calculating dividend yields and comparing with similar firms leads to a subjective evaluation of a company's worth.
Small business purchasers will rarely have the resources to buy a company outright. One of the common methods of assessing a business opportunity therefore is to verify that after the sale the business will generate enough cash to cover expenses as well service the debt used to acquire the company. An even simpler method is to use a multiple of cash flow to estimate a business value.
For well established firms within well understood industries sales and profit multiples are often used to arrive at a business value. All that is required is annual sales and an industry multiplier - often supplied by trade groups, financial publications or industry organizations which are usually a range of .25 to 1. Pre-tax profits and a multiplier (commonly 1 - 5) can also be used. Businesses that operate outside of these benchmarks require additional scrutiny. The speed and ease of these calculations comes at the cost of accuracy regarding a particular firm's prospects.
Market based approaches to valuation
Brokers and M&A specialists rely on Precedent Transaction Methods to arrive at business value - basically what the market says other such businesses are worth based on recent transaction values. They are seldom used exclusively to value a business as similar businesses may have substantial differences in performance or operations due to management, industry standing, goodwill and other factors that drive earnings.
Brokers and other business professionals often rely on their experience as well as their specialization within a market for similar businesses and industry averages (sometimes referred to as Rules of Thumb). Industry trends and means, available from trade groups and industry organizations, are useful bounding metrics but aren't much help with precise valuations. These methods are fast, cheap and easily agreed to as they are based on history and current market activity. And they are excellent for spotting trends or assessing desirability of certain markets or certain types of businesses. Strategic investors usually overpay for acquisitions and premiums given to favorable trends are among the reasons.
For larger public firms, there is an abundance of readily available data. P/E ratios are available for public companies and the availability of the information is valued as a premium - 35 - 70% because owning shares in public companies has less risk. Closely held firms have much less public information available so should be discounted appropriately. SMBs in the same industry as large public firms actually have little in common to use as a basis for comparison, though many SMB owners believe they should be compared to larger enterprises in the same industry.
Comparing similar public companies is routinely done with mergers or acquisitions made by larger firms of other large firms. There is little done in these circumstances applicable to buying or selling or valuing a smaller business. Public company method seeks to determine the reasonable value of stocks through watching trading patterns, comparison to industry standards and performance of peer group, can be used to determine break-up values and relies on well regarded published information for analysis. Companies within same industry, with the same capitalization and organizational structures or with similar growth rates and margins are used for comparison.
Conclusion
At the end of the process, the value arrived at either through negotiation, court proceeding or successful transaction is the true value - the amount someone would reasonably pay or the assigned value of your business. As suggested above valuations can be derived through a variety of methods, formulae and procedures. Public, private, courts, retail, manufacturers, service businesses, CPAs or appraisers may all have vocabulary or practices which are preferred or unique to their circumstances. And in most instances several iterations using the various methods will be used for assessing value. But then it all comes down to agreeing between the parties about what a business is worth. And the very best indicator of how much a business is worth is how much someone just paid you for it.
Recent Comments