Valuation 101

Click here for information relating to our Valuation services. Technical Reference Bulletin No. 101 Realistic Business Valuation It is a "hypothetical" selling price Have you heard that you can multiply your current earnings by 5 (or some other number between 3 and 8) to calculate the value of your business? Unfortunately, merely looking at last year’s financial statement and making an estimate is often incorrect and misleading. A realistic business valuation requires a thorough analysis of several years’ of the business operation, application of quantative methods and an opinion about the future outlook of the industry, the economy and how the subject company will compete. What is fair market value? IRS says it is “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. “   This is found in Rev. Ruling 59-60, written for the purpose of assessing estate, gift and other taxes. I believe . . . the IRS meant to say a “hypothetical” buyer. Under this concept, fair market value would assume no knowledge of a structured purchase transaction that may involve tax benefits, favorable interest rates and terms in a seller financed transaction. It is a “hypothetical” selling price. The IRS ruling does not assume that a willing transfer of ownership is even contemplated. What information is needed to value a business? First item on the agenda is to identify the purpose of the valuation. Valuation for purposes of divorce (partners included) or to satisfy ESOP requirements may produce different results than valuation for negotiating the sale of a company. For example, the split of a company into two may require analysis of the increased risk. This may result from a division where one business is left with a leaner capital structure than that of historical operation. In other words, the previous sales level at this division is not readily achievable as a stand-alone company. In this example, the value of the two parts may not add-up to the value of the company as a whole. For the purpose of discussion, let’s assume that the objective of the business valuation is to aid in negotiations to divest the company.   Remember the “garbage-in”  “garbage-out” phrase? Care must be taken to gather complete and accurate information before commencing the business valuation. Some of the analyst’s information needs include: • Industry and market share information • Receivable aging • Five years financial statements and tax returns • Inventory list • Corporate/ownership structure • Pending litigation • Asset depreciation schedule • Employment/union contracts • Property and equipment leases • Owner compensation In general, there are three basic types of 3 - Public market based techniques 2 - Cash flow based 1 - Asset based   Let's look at some valuation techniques The correct value of a business is an amount that produces a sustainable rate of return that is equitable for the risk So, let’s quantify some expected returns. For early stage startups venture capitalists seek a projected annual rate of return of 60% to 70% with the expectation that one in 10 investments will succeed. This high rate of return is matched with an equally high rate of risk of losing your investment. According to Ibbotson Associates, well known for their analysis of statistics, the corporate stock investor has earned an average   return of 10.3% a year since the end of 1925. The risk associated with investment in an established closely-held business is somewhere between the venture and the larger publicly-held business investment. Assessment of the traits of the subject company will reveal a quantifiable risk factor and capitalization rate that can be applied to the earnings of the company. It should be noted that general economic conditions affect the value of a business by increasing or decreasing the optimism for future profits. As the climate changes, the degree of risk also changes and capitalization rates are appropriately altered. Thus, the value of many small companies today may be no more than 65% to 75% of what it was in the 1980's. In Summary The valuation of a business is truly an art rather than a science. There is no precise, irrefutable “correct answer.”  Only an “opinion of value” or rational basis predicated on the application of the generally accepted valuation principles and the experienced judgment of an evaluator.  business valuations; Revenue Ruling 59-60 advocates finding a comparable publicly traded business to apply a comparable business factor. It is difficult if not unlikely that in large publicly traded company could be found that has the same product mix, distribution system and market as a small, closely-held business. If one were found, adjustments would be required to account for differences in financial stability and depth of management. Generally, public market based techniques are ruled out in favor of computing the value of a business based upon the asset value and capitalized cash flow produced by the business. When appropriately applied, these formulae will compute a range of possible values. In my opinion, the most accurate method to assess the value of a closely-held company is a capitalization of earnings. But what earnings? To the extent that future earnings can be confidently projected they will theoretically produce the most accurate value of the business. Unfortunately, projecting future economic conditions, future interest rates, unwritten tax benefits or assessments and other assumptions often erode the reliability of future earnings estimates. And what capitalization rate? Capitalization rates usually include inflation and an appropriate return for risk. At Business Exchange Center we believe that the correct value of a business is an amount which produces a sustainable rate of return that is equitable for the risk to be assumed. About the author: Lori King, CPA CBC was a principal in the Bellevue,Washington based business valuation firm, Business Exchange Center, Inc. Exchange is a publication of: BEC Advisors & Private Equity Services LLC 3003 Northup Way Suite 101 Bellevue, WA 98004 Ph. 425.635.5000 Valuations, Mergers, Acquisitions, Management buy-outs, Corporate Finance, Private Equity