This question can only be answered by addressing other related questions, specifically: Who’s asking and for what purpose?
From the perspective of the owner, prospective buyers, the IRS, lenders and
divorce & bankruptcy courts, the value of a business for purposes of a
sale, estate planning, orderly or forced liquidation, gifting, divorce, etc.
can be vastly different.
Intrinsically tied to the various purposes of valuation are numerous definitions
of “value.” Here are a few examples:
Investment Value – The value an acquirer places on
a business based on a future return on investment determined by assessing past
and current performance, future prospects, and other opportunities and risk
factors involving the business.
Liquidation Value – The value derived from the sale
of the assets of a business that is closed or expected to be closed following
Book Value – Book value is the difference between
the total assets and total liabilities as accounted for on the company’s
Going Concern Value – Used to define the intangible
value which may exist as a result of a business having such attributes as an
established, trained and knowledgeable workforce, a loyal customer base, in-place
operating systems, etc.
Fair Market Value – For the purpose of this article, the
focus will be on transaction related valuations. Fair Market Value (“FMV”)
is the most relevant definition of “value” and is of the most interest
to business owners. The more knowledge business owners and prospective buyers
have about the valuation process, the more likely they will come to an agreement
on a purchase price. (For more information, see the article in this issue titled “Common
Mistakes in Business Valuation.”)
FMV is the measure of value most used by business appraisers, as well as the
Internal Revenue Service (IRS) and the courts. FMV is essentially defined as “the
value for which a business would sell assuming the buyer is under no compulsion
to buy and the seller is under no compulsion to sell, and both parties are
aware of all of the relevant facts of the transaction.” IRS Revenue Rule
59-60 lists the following factors to consider in establishing estimates of
- The nature and history of the business.
- The general economic outlook and its relation to the specific industry
of the business under review.
- The earnings capacity of the business.
- The financial condition of the business and the book value of the ownership
- The ability of the business to distribute earnings to owners.
- Whether or not the business has goodwill and other intangible assets.
- Previous sales of ownership interests in the business and the size of
ownership interests to be valued.
- The market price of ownership interests in similar businesses that are
actively traded in a free and open market, either on an exchange or over-the-counter.
What is Goodwill?
An important element of value, when it exists, is goodwill. The IRS defines
goodwill in its Revenue Rule 59-60, stating, “In the final analysis,
goodwill is based upon earning capacity. The presence of goodwill and its value,
therefore, rests upon the excess of net earnings over and above a fair return
on the net tangible assets. While the element of goodwill may be based primarily
on earnings, such factors as the prestige and renown of the business, the ownership
of a trade or brand name, and a record of successful operation over a prolonged
period in a particular locality, also may furnish support for the inclusion
of intangible value. In some instances it may not be possible to make a separate
appraisal of the tangible and intangible assets of the business. The enterprise
has a value as an entity. Whatever intangible value there is, which is supportable
by the facts, may be measured by the amount by which the appraised value for
the tangible assets exceeds the net book value of such assets.”
Valuation Approaches and Methods
Exploring valuation techniques requires an understanding of the tools available.
Which tools are utilized depends in part on the purpose of the valuation and
the circumstances of the subject company. Generally there are several approaches
to valuing a business. Within these approaches, there are several different
methods. Listed below are the three major approaches along with some examples
of specific methods that fall under each category.
- Income Approach
- Discounted Cash Flow Method
- Single Period Capitalization of Earnings Method
- Market Approach
- Comparable Publicly Traded Company Analysis
- Comparable Merger & Acquisition Analysis
- Asset-Based Approach
- Adjusted Net Asset Method
- Excess Earnings Method
All of the above methods and approaches are frequently used in business valuations.
Normalizing the Financial Statements
Before the approaches and methods above can be applied, it is necessary to
analyze and normalize both the income statement and balance sheet of the business
for the current and past periods selected to form the basis of the valuation.
Normalizing the Income Statement
Normalizing the Income Statement generally entails adding back to earnings
certain personal expenses, non-recurring and non-cash items. Examples of these “add-backs” could
include depreciation, amortization, auto, boat and airplane expenses, one-time
extraordinary expenses and other excess expenses such as owner’s salaries
and family member’s salaries that are above fair market value, travel
and entertainment, bonuses, etc. Owners usually tend to be extremely liberal
when normalizing the income statement in order to bolster earnings, which can
artificially inflate valuation. Each item must be carefully analyzed and scrutinized
to insure that the normalization process is credible.
Normalizing the Balance Sheet
Normalizing the Balance Sheet includes adjustments that eliminate non-operating
assets and other assets and liabilities that are not included in the proposed
transaction, and therefore the valuation. The book value of the assets will
be adjusted up or down to reflect their fair market value. Inter-company charges
will also be eliminated. Inventory may be adjusted upward or downward based
on prior accounting procedures and/or obsolescence. Accounts receivable may
also require an adjustment based on an analysis of collectibility.
EBIT – An acronym for earnings before interest and taxes
EBITDA – An acronym for earnings before interest, taxes,
depreciation and amortization.
Capitalization Rate – Any divisor that is used to convert
income into value. This is generally expressed as a percentage.
Discount Rate – The rate of return that is used to convert
any future monetary gain into present value.
(Note: when determining FMV, the earnings stream selected to be capitalized
or discounted should be normalized.)
Even with all the terminology and definitions discussed above, the answer
to the original question has not yet completely been answered: What is the
The value driver of a business is the ability of the entity to generate future
cash flow or earnings. Business appraisers will assign an appropriate capitalization
rate (or multiple) to a selected earnings stream to derive an overall value
for a business. The value of the net assets of the business will be compared
to the cash flow valuation and may be adjusted upward or downward. For example:
if the earnings based valuation is less than the net asset value, an upward
adjustment may be in order. Conversely, if the net assets are negligible, a
downward adjustment is more likely to occur.
Many appraisers typically use a common range of multiples to arrive at a “ballpark” indication
of value (for example, 4 to 6 times EBITDA). While this approach is commonplace,
an in-depth valuation of the subject company will produce a more accurate result.
There are too many intangible factors to be considered to rely solely on the
capitalization of earnings. Of course, the ultimate value of a company will
be determined by the marketplace, which can greatly differ from a seller’s
expectation, as well as the expectations of potential acquirers.
It is not uncommon for business owners to have an inflated sense of value
of their company. This could be due to a variety of factors including emotional
attachment to the business, unwillingness to accept the impact of the risk
factors of the business, outside influence from previous market conditions,
incorrect conclusion of normalized earnings, comparable transactions, etc.
Conversely, acquirers often undervalue businesses. In their quest to “buy
right” they often end up paying a lower multiple for a company with serious
negative factors, while passing up on higher multiple opportunities, which,
due to the quality, are actually better buys.
Valuation is a complex process. Owners and buyers will be well served if they
rely on professional advisors such as their accountants, business appraisers,
intermediaries or investment bankers.