Although you may never put pen to paper [or finger to calculator] in working business valuation’s mathematical and analytical formulas, you want to understand them, particularly if you’re working with a qualified expert. No two businesses are exactly alike, even those in the same business operating across the street from one another. Having said that comparing similar companies can help you identify efficiencies and best practices that boost long-term value. Larger, more complex companies — and the increasing number of companies that consider intangible, intellectual assets the number one source of their value — may need to apply slightly different valuation methods and non-numerical analysis to get to the bottom of things. Not all companies need to go through a detailed valuation process. Generally, the smallest of small companies (businesses with less than $1 million in annual revenues is a guideline most valuation experts agree on) can rely on database information and rule-of-thumb measurements that go a long way to setting a range to negotiate price on any business.
Okay, so what’s the difference between an approach and a method to finding the value of a particular business? Think of an approach as the expressway you need to get to the right town, and think of a method as a way to get to the right address. Each approach has several methods. I explain the major ones in this post and note some additional techniques that people use.
The Three Major Approaches [Asset, Market and Income Approach]
The three top associations for valuation professionals — the American Society of Appraisers (ASA), the Institute of Business Appraisers (IBA), and the National Association of Certified Valuation Analysts (NACVA) — agree on three major approaches to business valuation:
- The Asset Approach
- The Market Approach
- The Income Approach
Some approaches are definitely more appropriate than others. The purpose of the valuation influences the ways the business must be valued, and so does the level of risk that business currently faces. That’s why valuation experts choose one or more approaches over others. The following sections cover these three major approaches in more detail.
The Asset Approach
Also known as the “Cost Approach“, the Asset valuation approach is based on your finding the fair market value of assets (the easiest ones to value are tangible assets) and deducting the liabilities to determine the net asset value or the net worth of the business. Fair market value is the amount that a willing buyer would pay to a willing seller in a free market for any piece of property, including a company.
Asset valuation methods include the following:
Book Value – In all honesty, book value really isn’t a valuation method, because book value shouldn’t be confused with fair market value — and that’s really why we mention it. The fair market value can be notably higher than the book value because the book value is based on the historic value of assets — primarily tangible assets. Equally important, book value essentially ignores goodwill, and for many small businesses, goodwill can be the biggest asset.
Book value isn’t a good measurement for evaluating a business before a sale, even for an industrial company that’s all about hard assets. Assets get depreciated over the years to a value of zero, but in reality, such equipment and other assets may still be valuable to the organization — depending on the quality issues associated with those assets, their value may actually go up. Yet it’s surprising to note how many companies believe that book value actually describes the full value of the business. Book value is included in a valuation report for the sake of completeness, but beyond that, it has limited use.
Here’s the formula for book value, which in some circles is called a business’s net worth:
Book Value = Total Assets – Total Liabilities
Using the tangible book value calculation, intangible or soft assets are deducted from the total assets. Economic book value, on the other hand, includes intangible assets and allows assets to be adjusted to their current market value.
Adjusted Book Value – This figure is the book value amount after assets and liabilities have been adjusted to market value, which involves comparing assets of similar companies or obtaining an asset appraisal (in use) from an accredited asset appraiser.
Why use it?: This method should be included in a valuation project for going-concern businesses (ongoing businesses, without plans to close in the immediate future) because it serves as a reality check of the other methods and tells you where the bottom of the value is for businesses with inherent goodwill. If some of the other valuation approaches indicate a value lower than the adjusted book value, the adjusted book value or orderly liquidation value may be a more appropriate valuation of the business.
There’s no actual formula for adjusted book value; you simply have to adjust book asset values to fair market values.
Liquidation Value – This calculation is somewhat similar to the book value calculation, except the value assumes a forced or orderly liquidation of assets rather than book value. In practice, the liabilities of the business are deducted from the liquidation value of the assets to determine the liquidation value of the business. The overall value of a business that uses this method should be lower than a valuation reached by using the standard book or adjusted book methods.
Why use it?: The word liquidation suggests that this is a process confined to businesses that are closing, are closed, are in bankruptcy, or are in industries that are in irreversible trouble. However, this method may also be the indicated method for a business that’s a going concern but that isn’t putting its assets to good use and may be better off closing down and selling the assets. Sometimes you hear the term orderly liquidation value, and you often see it applied to companies that are closing and selling off machinery, office equipment, and other tangible assets in a piecemeal fashion over time.
The Market Approach
With the Market Approach, you’re comparing your company or a target company with other, similar companies. You can use comparisons to similar publicly traded companies or to actual sales transactions or similar businesses.
You must make comparisons with caution. Comparing a small privately owned business with a publicly traded company without adjusting for size and tradability is inappropriate. Likewise, comparing a business with $100,000 revenue to a multimillion-dollar business concern is inappropriate.
Another important issue that may detract from the usefulness of comparisons is that the comparables are obtained from databases that track completed transactions. You may find too few comparable transactions to base an opinion on. In addition, some of the databases don’t disclose the terms of the transactions, and the terms may have an upward or downward effect on the price at which transactions close.
These valuations are frequently expressed in ratio form. You can use several ratios for this method of valuation, and as the importance of intangibles continues to grow, you’ll probably see new methods evolve in the future.
Here I list the most commonly used measures:
Price-To-Revenue Ratio: This is expressed as the market price of the business divided by the revenue.
Why use it?: Even if a company hasn’t posted a profit over the past year, it always has revenue. This valuation measure is frequently applied to younger companies or businesses in high-growth industries. Also, depending on how the financials are normalized (and how earnings are calculated), the number most easy to verify may be the gross revenues of a business.
Price-To-Earnings Ratio: The P/E ratio is expressed as the market price of a business divided by earnings.
Why use it?: Earnings are the lifeblood of a company — without earnings, it can’t continue over a long period of time.
Price to EBITDA: This ratio is expressed as the company’s share price divided by its earnings before interest, taxes, depreciation, and amortization.
Why use it?: Using EBITDA improves comparability among businesses because it removes expenses that are or may be somewhat subjective.
The Income Approach
The Income Approach is probably the most common and appropriate valuation approach in most cases. Essentially, you’re trying to analyze the future economic benefits you’re anticipating from a business — better known as income — into a single amount in today’s dollars, the term also known as present value.
You can say this another way: The Holy Grail of valuation based on income assumptions is the determination of future earnings, also known as the future benefit stream, or in other words, “big profits I expect to pocket if I buy this company” (If you don’t want to see evidence of a company that’s going to grow and make more money from year to year, why would you buy it?)
Valuation based on income and cash flows tries to project a company’s future cash flows based mainly on historical financial data added to smart analysis of the company’s current operations and plans for the future — anything expected to enhance the amount of money coming in the door. This past financial data should be audited data that has come from a respected accounting firm that’s willing to sign its name to its work, if possible. That gives you accountability for those results. However, the Income Approach is suited for less-accountable data also because the approach gives you the ability to take into account the higher potential risk associated with an unaudited income stream.
In the smallest of small companies — and surprisingly, in some larger ones as well — don’t be surprised if you run into financial data done by someone’s Uncle Morrie. Uncle Morrie may be a crackerjack accountant and as honest as the day is long, but it’s best to have a CPA with some experience auditing the finances of your particular industry doing your figures before you turn them over to a buyer. If sellers want a higher price, they need to think like buyers and make a more professional presentation of their financials.
Risk Calculation And Its Relationship To Present Value
Companies with smart growth plans, solid financial controls, and good leadership build value. Knock out any of these three attributes, and the three-legged stool wobbles. The evaluation of risk and its relationship to present value is what valuation professionals — and some of the smartest minds at the biggest companies in the country — get paid to do. They look for signs of solid management, but they also look for trouble. Ironically, trouble isn’t always a turnoff, because trouble often can be managed and overcome. Risk isn’t necessarily a bad thing if adjustments are possible.
Whether you’re buying a business outright or a stock in any company as a personal investment, you need to determine whether that company’s potential future reward outweighs the potential risks of getting in. This fact is true whether the company is a high-flying Internet startup or a corner family restaurant. If you’re buying a business outright, you should also come to the process with an idea of how to limit that business’s risk in the future — art can trump science in this part of the valuation process.
You always have to monetize the future in the present to see if it’s worth jumping on board. Present value is the central question of valuation; the simple definition is the current value of one or more payments to be received or paid in the future. The more interesting question is why present value is important. When you’re buying or selling a company, you’re literally buying or selling the future.
Why would anyone buy a company that has no positive prospects after the end of this week, month, or year — or in five years?
Business valuation is focused on the concept of present value because you need to put an actual price tag on that future if you want to profit as a buyer or a seller. In valuation terms, a discount rate is a rate of return on investment used to calculate the present value of a series of cash flows to be received in the future. More colloquially, a higher discount rate can be applied to particular assets that have a higher degree of risk — read that as questionable value.
Using “Discount and Capitalization Rates” and “Income Valuation Methods”
Some people describe a discount rate and a capitalization rate as separate concepts; others use the terms interchangeably. I’ll just say that both concepts are the result of the build-up method in valuation. That means a valuation professional uses a variety of factors — hard numbers as well as judgment calls based on industry research — to “build up” a variety of numbers and reach a critical piece of information: whether it’s smarter for a potential buyer to sock her funds in this business or simply invest the money elsewhere.
In the context of business valuation, a discount rate gives that answer before certain tax, cost-of-capital, and cash-flow adjustments are made. The capitalization rate is the final measurement that comes after those final adjustments.
The discount rate can alternatively be called a required rate of return — what you’re expecting the investment to yield, considering how risky it is. As such, it’s essentially a measure of the risk of an investment. It’s determined by building risk factor on risk factor until you’ve considered all the potential risks in an investment.
What kind of numbers go into calculating a discount rate?
A business valuation professional builds up a discount rate by starting out with a risk-free rate (usually the T-bill rate) and gradually building risk factors onto the risk-free rate until all the risk factors related to the business being valued have been taken into account. Here’s how it works:
- The first addition is a market risk premium over the risk-free rate, to bring the rate to what can be expected from an investment in a publicly traded company (with average industry risk).
- The second adjustment is an adjustment for industry risk (some industries trade at a higher market risk premium than others because of industry risk).
- The next risk premium relates to the size of the business.
- Thereafter, the valuation professional adds or deducts premiums for company-specific information that was uncovered during the analysis of the business.
A Case Example
Consider an example of how the resultant discount rate is used. You have a business in your sights that you want to invest in and you know that your annual return from this business will be $100,000. You do some research and figure out that 33 percent is a standard capitalization rate for other businesses this size that operate in the same industry — that 33 percent is your capitalization rate here. So you do the math:
$100,000 / 0.33 = $300,000
That $300,000 is the actual value of the investment. Should you pay $300,000 for that business? See whether you can get it for less.
When determining discount and capitalization rates, you have the option to use either the build-up method or the capital asset pricing model (CAPM) method. If you’re valuing the company on a debt-free basis, you can convert the discount and capitalization rates to their debt-free equivalents based on the company’s weighted average cost of capital.
The paragraphs cover the most common income valuation methods. Read on…
Capitalization of Earnings Method
The “Capitalization of Earnings Method“ reflects the previous calculation: It takes an earnings number from a particular period and computes the value of the entire investment when divided by a particular capitalization rate. Here’s the formula:
Income before Depreciation, Interest, and Tax (IBDIT) / Cap Rate = Value
This basic method determines the value of a business’s capital asset pricing and your strategy for negotiation. However, keep in mind that this method assumes that the business will grow at a stable rate every year or won’t grow at all.
Discounted Cash Flow (DCF) Method
The DCF Method calculates the present value of future expected cash flows using a selected discount rate. People usually use it when a company’s earnings growth is different from year to year (the company may be growing exponentially, or it may be unstable for a variety of reasons, good or bad). DCF analysis is usually applied to companies that are rather young or companies that are experiencing high growth (Note that young businesses that are still experiencing variable growth may also be more risky)
Each of the company’s individual cash flows is discounted to a present value by using a discount rate over a discrete number of periods. At the end of the period, usually when it’s assumed that the company’s earnings have stabilized, a terminal value is calculated by using a capitalization rate. All the various values are summed to arrive at an overall value of the cash-flow stream.
Management of the business to be valued should provide the future cash flows and the assumptions they’re based on, and the valuation professional should carefully and critically assess them. If you’re assessing your own business, make every attempt to approach the process with a good dose of realism.
Here’s the DCF formula:
DCF = CF0 × the sum of [(1 + g) / (1 + r)x] (for x = 0 to n)
where: DCF is discounted cash flow, CF0 is today’s cash flow, g is expected growth, r is the expected rate of return, and n is the number of periods (which is usually not more than three to five years).
However, you’re not done yet. What you’ve done so far with the discounted cash flow doesn’t include the prospects of the business after the discrete period years, and you sincerely hope that the business will continue on into the future. At this point, you need to make an educated guess regarding what may be expected as a long-term growth rate into the future and then use this information to determine the terminal value at that time.
The terminal value can be determined by using the Gordon Growth Model, as follows:
Price = I / (R – g)
where: I is the annual cash flow at the end of the discrete period, R is the risk or the discount rate, and g is a constant growth rate into perpetuity. This calculation gets you to something called a terminal value at the end of a period when the company’s growth rate is expected to become stable.
Consider the methodology examples you see here as the most common, but realize that many more techniques can reach valuation conclusions based on particular industries and situations. In many valuations, you see a professional use more than one approach and methods within that approach to test valuation from a number of perspectives.
Weighted Average Cost of Capital
The WACC Method can help a company calculate the cost of raising money. The calculation involves multiplying the cost of each element of capital, such as debt (loans and bonds) and equity (common stock and preferred stock) by its percentage of the total capital and then adding them together. The final figure, the weighted average cost of capital (WACC), is a rough guide to the rate of “required return” per monetary unit of capital.
Take a look at the formula:
WACC = [Ke + Kd(D/E)] / [1 + (D/E)]
where: Ke is the desired return on equity, Kd is the desired return on debt, and D/E is the debt/equity ratio.
Excess Earnings Method
I am not exactly in love with the Excess Earnings Method. In fact, some people like to call it the Etch A Sketch Method. This method gets a lot of attention for the valuation of companies with significant intangible assets, but it’s also earned a fair amount of controversy. Here’s how it works:
- The market value of net tangible assets is multiplied by a rate of return appropriate to these assets to calculate earnings attributable to tangible assets.Net tangible assets are calculated first, and then an assumption is made about whether those tangible assets should provide at least a basic return on investment, such as 10 to 15 percent.
- This earnings figure is deducted from total earnings to calculate an earnings figure attributable to intangible assets. After that return is calculated, the difference between that return and the company’s actual cash flow is the amount of cash flow attributable to intangibles.
- These intangible earnings are divided by a capitalization rate for intangibles to calculate an estimated value for the intangibles.
You now have the value of the intangibles — in very, very rough terms at least.
A lot of potential for inaccuracy arises with the Excess Earnings Method, particularly among neophytes. The level of subjectivity is very wide.
What rate should a net tangible asset return — 10, 15, or 20 percent?
A delivery truck has a different expected contribution than a piece of machinery on the plant floor, and depending on which one you pick, it has either less or more of an impact on the intangible calculation. A question also arises over what capitalization rate to use for intangible assets, and most people place that rate at a high level.
The IRS developed the Excess Earnings Method during Prohibition to compensate distilleries for putting them out of business during the Volstead Act. More sophisticated techniques have evolved since then.
So why use it? A lot of people love this method because it’s a relatively easy one to do. But leave it to the IRS to be a wet blanket: The agency once thought the method was okay to use, but now it denounces it because depending on the calculation, some firms can create much more value than they’re entitled to. Yet some people are still attracted to this method when they’re reporting higher earnings than they normally do.
But back to the capitalization rate. When you hear the term capitalization of income, it’s the way the economic worth of a company is estimated by computing the present value of average annual net income that the company is expected to produce in the future.
Projecting future income isn’t just a matter of numbers — it involves applying certain assumptions about the risk and reward of a particular business investment. As you see in the preceding computation, a cap rate requires research and comparison with other similar companies — but the computation works for stock investments, machinery, or any asset.
Another way to explain the capitalization rate is as the yield necessary to attract investors to a particular investment, given the risks associated with that investment. And in the world of investing in businesses or in securities, the greater the risk, the greater the potential for reward.
What are some of the nonnumeric risk factors that get built into capitalization and discount rates that valuation professionals apply?
I list a few here:
- Strong product lines
- Talented management
- Strong customer base
- Dominant market share
- Great financial controls
- Low employee turnover (and for some valuations, no unions are a plus)
- No hidden liabilities that may blow up into expensive lawsuits
- Financial ratios that exceed other companies in its industry class
Numbers are sort of like paint on a canvas: Mix them one way, and you get a particular shade. Mix them a different way, and they change. Valuation experts use a lot of different shades of earnings and other financial data in their work because they want those numbers to tell them specific things. Here are some definitions of key earnings measurements that are woven into many valuation projects:
Normalized net earnings: Also known as normalized earnings, these are earnings results that have been adjusted (there’s that word again) for unusual one-time issues, non-GAAP (generally accepted accounting principles) practices, discretionary expenses, or cyclical moves in the economy.
Earnings before taxes (EBT): EBT is a way to compare companies in different tax jurisdictions. Here’s the formula: EBT = Revenue – Expenses (excluding tax).
Earnings before interest and tax (EBIT): EBIT is essentially a company’s operating earnings before deducting interest and tax payments. It’s a purer look at a company’s ongoing ability to profit, and it can make for easier comparisons across business lines and other companies. Here’s the formula:
EBIT = Revenue – Operating Expenses
Earnings before interest, taxes, depreciation, and amortization (EBITDA): This measurement gets a lot of mileage during earnings season for public companies. It’s a controversial favorite: Analysts use it to compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions, which allows some companies to hide a lot (remember Enron?). Here’s the formula:
EBITDA = Revenue – Expenses (excluding tax, interest, depreciation, and amortization)
Net cash flow: Cash flow is the lifeblood of a business because it measures a business’s ability to pay its expenses on time while continuing to grow the operation. Here’s the formula:
Net Cash Flow = Cash Inflows – Cash Outflows
Free cash flow: This figure is the amount of cash that a company has left over after it has paid all its expenses and purchased all the capital assets it requires to maintain the business. How do you get there? Start with a company’s operating cash flows (net income plus amortization and depreciation) and then subtract capital expenditures and dividends:
Free Cash Flow = (Net Income + Amortization + Depreciation) – (Capital Expenditures + Dividends)
Accounting10 years ago
Check Payment Issues Letter [Email] Templates
Accounting10 years ago
What is Journal Entry For Foreign Currency Transactions
Accounting6 years ago
Accounting for Business Acquisition Using Purchase Method
Accounting10 years ago
How To Calculate And Record Depreciation [of Fixed Asset]