Last month we discussed The Comparables Price Method, The Capitalization of Earnings Method, and the Net Tangible Asset method of business valuation. This month we go on to discuss additional methods that are used and weighted in order to arrive at a valid and reliable valuation.
Present Value of Future Income Stream (Leverage Cash Flow Debt Method
A variation of the capitalization of earnings method is referred to as the “Leveraged Debt Concept.” This concept takes into consideration the fact that an outside party may leverage an acquisition of the current company and use all of the income to pay the interest on borrowed money. Currently the cash flow method is becoming more important in valuations as companies tend to “free cash”, I.e. earnings before interest, taxes, depreciation, and amortization. (EBITDA)
Excess Earnings Capacity (Goodwill)
This method is based on the theory that the value of a company is equal to the value of the net tangible assets plus the value of excess earnings (e.g.., goodwill, patents, trademarks, copyrights, etc.). Eight factors are typically considered when calculating goodwill: age of the company, employee turnover, the value of the suppliers and the products sold, market area, potential growth, inventory efficiency, company location, and banking relationships. Excess earnings attributable to intangible assets are the foundation of the value of goodwill. Once this calculation is made, the result is added to the adjusted asset value as identified alone in the Asset Approach.
Net Income Residual Approach or Dividend Paying Capacity
This method looks at the income that is left over for the stockholders as it relates to a company’s return on investment. Effectively, it can be referred to as the ability of the company to pay dividends to the stockholders using income that is not needed to operate the business in the future. Dividends are based on earnings after taxes as they relate to investment (stockholder’s equity) at the beginning of the year. Dividends represent the after-tax earnings that are distributed to the stockholder instead of being kept in retained earnings to help finance future projects. This is a key method to determining what an investor would pay for participating in the operations of a privately held company.
In theory, purchasing a business is comparable to purchasing a corporate bond. When the bond is purchased, the corporation or governing entity pays the holder interest for the stated term of the bond usually in 6 month increments or so. At the end of the term of the bond, the holder is repaid the value of the bond.
A business, on the other hand, operates in much the same manner, or at least it should. Upon purchase of the business, the owner benefits from the activity of the business and either draws or is paid some kind of distribution or dividend (depending on the type of entity). Though obtained in a different manner, these payments are similar to the interest paid in a bond. Upon retirement, death or exiting the business, the business owner is entitled to the fair value of the business (similar to cash in value of the bond) including a terminal value. While it is not paid out automatically, the terminal value may be obtainable through sale of the company to the next person.
Often, the terminal value, adds more than 50% to the value of a business. This is the same with corporate bonds. Often, if the value of a bond is broken down, the income stream is worth 25 – 40%, while the residual value is worth 60 – 75% of the bonds value.
Next month, we will discuss Year End Tax Planning. Tax Planning this year saves Tax Paying Grief next year!
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors