The Need and Methods Behind a Valuation
Along with deciding to engage in business succession planning and finding a successor, it is necessary to value the business. A valuation is necessary whether the business is to be transferred either to an heir or third party. 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 including purposes which blend into each other. 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. Following is a brief discussion of different valuation methodologies.
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 the benchmark value. The individual company values can then be weighted and an industry benchmark can then be established.
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 through five years and projects the earnings potential for up to five years, 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. 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 personnel. 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 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.
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”.
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.
Several methods of valuing a closely-held company have been presented in this section. Each method has its advantages and disadvantages. Furthermore, no single method provides the absolute value of a company. The appraiser must determine which method will receive the greatest weights based upon the relative importance of each method to the overall success of the company. (10-07)
About the author:
Dr. Bart A. Basiis an expert on closely held companies, an attorney, a Certified Public Accountant and the President of the Center for Financial, Legal & Tax Planning, Inc. He is a member of the American Bar Association’s Tax Committees on Closely-Held Businesses and Business Planning.
Basi & Basi at The Center for Financial, Legal & Tax Planning, Inc.
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