Determining the value of a company is the part of the buy/sell transaction most fraught with potential for differences of opinion. Buyers and sellers usually do not share the same perspective. Each has a distinct rationale and that rationale may be based on both logic and emotion.
The buyer may believe that the purchase will create synergy or economies of scale because of the way the company will be operated under new ownership. The buyer may also see the business as an especially good life-style fit that provides a measure of psychic income. These factors are likely to increase the amount of money a buyer is willing to pay for a company. The seller may have a greater than normal desire to sell due to financial difficulties or the death or illness of the owner or a member of the owner’s family.
For the transaction to come to conclusion, both parties must be satisfied with the price and be able to understand how it was determined.
Factors that Determine Value
Ultimately, the true value of any business is determined directly by the negotiation between the business owner and the buyer. The marketplace is the only true and accurate valuation method… a business is worth what a qualified buyer is willing to pay for it.
The topic of business valuation is so complex that any explanation short of an entire book does not do it justice. The process takes into account many variables and requires a number of assumptions. Shannon Pratt,* a noted business valuation expert, names six important factors:
1. Recent profit history.
2. General condition of the company (such as condition of facilities, completeness and accuracy of books and records, morale, etc).
3. Market demand for the particular type of business.
4. Economic conditions (especially cost and availability of capital and any economic factors that directly affect the business).
5. Ability to transfer goodwill or other intangible values to a new owner.
6. Future profit potential.
These six factors determine the fair market value. However, businesses rarely change hands at fair market value. Pratt lists three other factors that often come into play in arriving at an agreeable price:
1. Special circumstances of the particular buyer and seller.
2. Trade-off between cash and terms.
3. Relative tax consequences for the buyer and seller, which depend on how the transaction is structured.
Fair market value can be defined as the price at which property would change hands between a willing buyer and a willing seller, both adequately informed of all material facts and neither compelled to buy or to sell. In the marketplace, however, buyer and seller are nearly always acting under different levels of compulsion.
* Shannon Pratt, Valuing Small Businesses and Professional Practices (Homewood, Illinois: Dow-Jones Irwin, 1986).
The rule for using rule-of-thumb formulas for pricing a business is: Don’t rely on them. The problem with rule-of-thumb formulas is that they address few of the factors that affect a company’s value. They rely on a one-size-fits-all approach when, in fact, no two companies are identical.
Rule-of-thumb formulas do, however, provide a quick means of establishing whether a price for a certain business is in the ballpark. Formulas exist for quite a few industries. They are normally calculated as a percentage of either sales or asset values or a combination of both.
Using comparable sales as a means of valuing a company has the same inherent flaw as rule-of-thumb formulas. Rarely, if ever, are two companies truly comparable. However, companies in the same industry do have some characteristics in common and a careful contrasting may allow a conclusion to be drawn about a range of values.
Balance Sheet Methods of Valuation
This approach calls for the assets of the company to be valued. It is most often used when the company generates earnings primarily from its assets rather than from the contributions of its employees or when the cost of starting a business and getting revenues past the break-even point doesn’t greatly exceed the value of the business’s assets.
There are several balance sheet methods, including book value, adjusted book value and liquidation value. Each has its proper application. The most useful is the adjusted book value method. This method calls for the adjustment of each asset’s book value to equal the cost of replacing that asset in its current condition. The total of the adjusted asset values is then offset against the sum of the liabilities. The result is the adjusted book value.
Adjustments are frequently made to the book values of the following items:
* Accounts receivable — Often adjusted down to reflect the lack of collectability of some receivables.
* Inventory — Usually adjusted down since it may be difficult to sell off all of the inventory at cost.
* Real estate — Frequently adjusted up since it has often appreciated in value since it was acquired.
* Furniture, fixtures and equipment — Adjusted up if those items in service (probably more than a few years) have been depreciated below their market value or adjusted down if the items have become obsolete.
Income Statement Methods of Valuation
Although a balance sheet formula is sometimes the most accurate means to value a company, it is more common to use an income statement method. Income statement methods are most concerned with the profits or cash flow produced by the company’s assets. One of the more frequently used is the discounted future cash flow method. This calls for future cash flows (before taxes and before debt service) of the business to be calculated using the three-step formula below.
Historical cash flows are a good basis from which to project future cash flows. Computation of cash flows include the following:
1. The net profit or loss of the company.
2. The owner’s salary (in excess of an equivalent manager’s compensation).
3. Discretionary benefits paid the owner (such as automobile allowance, travel expenses, personal insurance and entertainment).
4. Interest (unless the buyer is assuming the interest payment).
5. Nonrecurring expenses (such as nonrecurring legal fees).
6. Non-cash expenses (such as depreciation and amortization).
7. Equipment replacements or additions. (This figure should be deducted from the other numbers since it represents an expense the buyer will incur in generating future cash flows).
While the future cash flows may be projected for a few years, for many small companies it is meaningless to attempt projections very far into the future. Even with somewhat larger and more substantial companies, it is difficult to project cash flow for more than five years.
Once future cash flows have been projected, they must be discounted to their present value. This is done by selecting a reasonable rate of return or capitalization rate for the buyer’s investment. The selected rate of return varies substantially from one company to the next and is largely a function of risk. The lower the risk associated with an investment in a business, the lower the rate of return required. The rate of return required is usually in the 2050 percent range and, for most businesses, it is in the 3040 percent range. The present value of the future cash flows can be determined by using a financial calculator or a set
of present value tables available from most bookstores or libraries. Table 1 demonstrates how the conversion is made with a 25 percent rate of return.
Table 1 — Calculation of Present Value of Future Cash Flows
Year Projected Discount Present
cash flow factor* value
Year 1 $950,000 .800 $760,000
Year 2 $1,025,000 .640 $656,000
Year 3 $1,125,000 .512 $576,000
Year 4 $1,250,000 .410 $513,000
Year 5 $1,375,000 .328 $451,000
* Based on a 25 percent rate of return. The discount factor declines in each succeeding year.
** Present value of the sum of discounted projected cash flows. This figure is added to the residual value of the business to arrive at the total value of the business.
One more calculation must now be done — the residual value of the company. The residual value is the current value of the company’s estimated net worth at the end of the period of projected cash flows (in this example, at the end of five years). This is calculated by adding the current net worth of the company and future annual additions to the net worth. The annual additions are defined as the sum of each year’s after-tax earnings, assuming no dividends are paid to stockholders. These additions are added to the current net worth and that total is
discounted to its present value to yield the residual value. The residual value is then added to the present value sum of the projected future cash flows previously computed to arrive at a price for the business. These calculations are shown in
Table 2 — Calculation of Net Worth Using Residual Value
Year After-tax income
Year 1 $550,000
Year 2 $590,000
Year 3 $650,000
Year 4 $700,000
Year 5 $775,000
Total additions to net worth $3,265,000
Current net worth $1,575,000
Total net worth $4,840,000
Residual value: $4,840,000 x .328 $1,588,000*
* Multiplying the total net worth by the discount factor used in the final year of projected cash flows yields the residual value. Adding the residual value of $1,588,000 to the present value sum of projected future cash flow of $2,956,000 (from Table 1) yields a value for the business of $4,544,000.
Although this three-step formula is widely used, it cannot be applied in this simple form to arrive at a definite value conclusion. It fails to address issues such as the buyer’s working capital investment, the terms of the transaction or the valuing of assets such as real estate that may not be needed to produce the projected cash flows.
It is best to retain a professional with business appraisal experience to get a more precise value.
Also see: Due Diligence
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