Along with deciding to engage in business succession planning and finding a successor, it is necessary to value a business. A valuation is necessary whether the business is to be transferred to an heir or third party or for retirement purposes. If the business is transferred to an heir, it is critical that the fair market value of the business be established in a well-supported form. If the business is to be sold to a third party, a valuation will ensure maximum value will be achieved.
A business valuation is a report written by a qualified appraiser for purposes including business succession, estate and tax planning, litigation, buy-sell situations and many other purposes. Given that purposes behind business valuations differ, methodologies also differ. Some methods are imposed by the Internal Revenue Code, others by common law, some by contractual agreement, and others by industry. The following is a brief discussion of different valuation methodologies that are used by appraisers.
The comparable price method operates under the assumption that there are other companies comparable to the business being valued that are either publicly-held or privately-held that recently sold. The IRS suggests that when using this method, at least three comparable companies must be used. Once the comparables have been found, the net income, cash flow, EBITDA, and the price/earnings ratio is used to compute a benchmark value. The individual company values can then be weighted and an industry benchmark can then be established. Many appraisers use this method to verify their own work using some of the following methods.
Capitalization of Earnings
The consensus among appraisers is that the capitalization of earning power is “the most important single factor in the valuation of most operating companies, such as manufacturers, merchandisers, and companies providing various services.” At the end of the life of a company, the total worth of that company can be found in the ability it had to generate earnings. This method uses historical data to project future earnings. The method goes back up to a maximum of five years and projects the earnings potential for up to five years in the future, using a growth rate, present value calculation, and expected earnings figures.
Adjusted Book Value (Net Tangible Assets)
This method, also referred to as the underlying asset value method, is especially useful in valuing holding companies versus operating companies. Investment houses and real estate companies are examples of holding companies. This method is also useful for liquidation purposes because it provides the “adjusted” asset value which relates to the fair market value of assets. It is also useful in valuing capital intensive businesses that rely on their asset base to perform work and generate income and create goodwill. An excellent example of this is a construction company. The company’s machinery is vital to their operations. This idea can be contrasted with a law practice whose income generating ability does not rest on physical assets of the firm but, rather, on personal ability. The key to this method is to determine the fair market value of all useful assets versus the value as stated on the books of the company.
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 (as calculated in the adjusted book value method) 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 determined above to arrive at a total value of a company.
Present Value of Future Income Stream (Leveraged 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 determine their “free cash”, i.e. earnings before interest, taxes, depreciation, and amortization (EBITDA).
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.
Each method has its advantages and disadvantages. Furthermore, no single method provides the absolute value of a company. The courts, as well as the IRS, have determined that more than one method must be used to value a closely-held corporation. The type of company, the purchaser, and the reason the company is being valued are important.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors