You as business owner had invested the time, money, and resources to work and grow your business. Yet, about 80% of small business owners do not have a business valuation plan. Why? Because most are working to grow their business and do not realize that valuation planning strategies are crucial to know the value of their business in order to manage risk, create succession planning for their business, plan for retirement and overall business planning.
Not knowing the real value of your business entirely deceives the purpose of you being on business!
Here are some insights on how to valuate your business.
1. Cost Approach
The cost (or asset-based) approach derives value from the combined fair market value (FMV) of the business’s net assets. This technique usually produces a “control level” value, meaning the value to an owner with the power to sell or liquidate the company’s assets. For that reason, a discount for lack of control (DLOC) may be appropriate when using the cost approach to value a minority interest. This approach is particularly useful when valuing holding companies, asset-intensive companies and distressed entities that aren’t worth more than their net tangible value.
The cost approach includes the book value and adjusted net asset methods. The former calculates value using the data in the company’s books. Its flaws include the failure to account for unrecorded intangibles and its reliance on historical costs, rather than current FMV. The adjusted net asset method converts book values to FMV and accounts for all intangibles and liabilities (recorded and unrecorded).
2. Market Approach
The market approach bases the value of the subject business on sales of comparable businesses or business interests. It’s especially useful when valuing public companies (or private companies large enough to consider going public) because data on comparable public businesses is readily available.
Under this approach, the expert identifies recent, arm’s length transactions involving similar public or private businesses and then develops pricing multiples. Several different methods are available, including the:
Guideline public company method. This technique considers the market price of comparable (or “guideline”) public company stocks. A pricing multiple is developed by dividing the comparable stock’s price by an economic variable (for example, net income or operating cash flow).
Merger and acquisition (M&A) method. Here, the expert calculates pricing multiples based on real-world transactions involving entire comparable companies or operating units that have been sold. These pricing multiples are then applied to the subject company’s economic variables (for example, net income or operating cash flow).
Under the market approach, the level of value that’s derived depends on whether the subject company’s economic variables have been adjusted for discretionary items (such as expenses paid to related parties). If the expert makes discretionary adjustments available to only controlling shareholders, it may preclude the application of a control premium. If not, the preliminary value may contain an implicit DLOC.
3. Income Approach
When reliable market data is hard to find, the business valuation expert may turn to the income approach. This approach converts future expected economic benefits — generally, cash flow — into a present value. Because this approach bases value on the business’s ability to generate future economic benefits, it’s generally best suited for established, profitable businesses.
The capitalization of earnings method capitalizes estimated future economic benefits using an appropriate rate of return. The expert considers adjustments for such items as discretionary expenses (for example, for above- or below-market owner’s compensation), nonrecurring revenue and expenses, unusual tax issues or accounting methods, and differences in capital structure. This method is most appropriate for companies with stable earnings or cash flow.
The discounted cash flow (DCF) method also falls under the income approach. In addition to the factors considered in the capitalization of earnings method, the expert accounts for projected cash flows over a discrete period (say, three or five years) and a terminal value at the end of the discrete period. All future cash flows (including the terminal value) are then discounted to present value using a discount rate instead of a capitalization rate.
As with the market approach, the income approach can generate a control- or minority-level value, depending on whether discretionary adjustments are made to the future economic benefits.
Important Decision
No universal formula exists for all businesses. Therefore, it’s essential for experts to explain why they chose a specific method (or methods) over all the possible options.
Courtesy of
Janix Barbosa-LLanos, MBA, PMP, CFPR
Independent Insurance Agent and Estate Planner
www.janixlife.com