How to Value a Business

A business valuation is vital when buying or selling a company. As a buyer, you must know how to value a business to make sure you do not overpay. As a seller, you must also know how to value a business so that you do not give up value you worked so hard to create.

There are tried and true methods of valuing businesses. Too often the selling price of a business is simply whatever the owner wants for it. It is rarely the correct value. Let’s see how a business valuation is done.

How to value a business - three methods.

The asset approach.

The book value method.

With this method the assets are valued at their historical cost. This method is rarely used as most assets have a value much different than what they originally cost.

The adjusted net assets method.

This commonly used method values the assets at their fair market value. This may require the use of both real property appraisers and personal property appraisers to assign proper values to the underlying assets.

The liquidation value method.

With this method the assets are valued at a price most likely to be received in an orderly and rapid liquidation of the assets. This can be appropriate when a company is in bankruptcy or is being quickly liquidated to payoff debts of the business.

The limitation of each of these, when determining how to value a business, is that they do not consider the earnings capacity of the company and thus miss the goodwill value that may exist.

The asset approach tends to be most valuable in situations where there is no value beyond the assets (that is no goodwill or blue sky value.)

The adjusted net assets method is the most often used of these variations. Book value, due to a failure to take into account the market value of the assets is usually inferior to the adjusted net assets method. The liquidation value method is only appropriate when a company is in a liquidation mode. The rapid liquidation would result in lower values being obtained.

The market approach.

When we think about how to value a business we find the approach very similar. A search is made for comparable sales of other businesses throughout the country. If enough comparable sales are found this will be very useful in determining value.

To see if businesses are comparable there are a number of factors to be considered including: capital structure, credit status, depth of management, personnel experience, nature of competition, maturity of business, products, markets, earnings, book value and position of the company in the industry. Unfortunately, it can be difficult to find truly comparable businesses based on these criteria.

In order to use this method of business valuation one must have access to and search company sales in published databases of such transactions. Due to the fact that there are fewer comparable sales to be found, data spanning several years must be considered. Typically, without professional help, this information is not readily available.

Warning: do not fall prey to looking through lists of businesses for sale to get an idea of what the business may be worth. Those prices are asking prices and not the actual value or what the business will really sell for.

The income approach.

A quick and dirty shortcut on how to value a business.

The risk can be equated with the rate of return you’d expect to earn for investing your money in the purchase of the business. In many small business valuations that rate of return is between 20 and 30 percent.

Example: Assume that you have determined that a business will have $100,000 a year in excess cash flow. If you said the rate of return you’d require to invest your hard earned dollars in buying the business was 25 percent, you’d have what you need to determine value. $100,000 divided by 25 percent is $400,000. That means that if you paid $400,000 for the business and it paid out $100,000 a year in cash flow, you’d be earning the 25 percent return you desired.

Now that is a very simplistic explanation of how a business valuation is done. There is much more that goes into determining the cash flow of a business and the rate of return to use. I highly recommend you at least read the rest of this article on business valuation to get a flavor for it.

Perhaps you can fine tune your own attempt at value, or you may decide to get a business valuation professional involved. When the dollars are significant it may make sense to hire a CPA or a Certified Valuation Analyst to do the valuation for you. There is that old saying: you get what you pay for!

An in depth look at the income approach.

The future benefits may be described as gross revenues, net operating profits, net income before or after tax, operating cash flows, or net cash flows before or after tax. Selection of the appropriate benefit stream is a matter informed judgment.

My preference, when asked how to value a business, is after tax cash flow. Given the preference for after tax cash flow, I will highlight the capitalization of earnings variation of the income approach.

The capitalization of earnings method.

How to estimate the after tax cash flow of a business.

The five years worth of information is averaged to find what a hypothetical average year in the business might look like. It is not unusual to weight the information amongst the years giving more weight to the most current years as being more relevant than older years.

Do not simply take the information from a tax return or financial statement without first making some adjustments though. I have never done a business valuation that did not require some adjustment to the numbers to make them valid for the business valuation. This is called the process of normalization.

How to normalize a financial statement.

Normalizing adjustments could include elimination of the effects of discontinued operations, elimination of the effects of nonrecurring events (like a major theft), adjustment for owner salaries that are much higher or lower than market rates, rent paid to an owner for business property at rates above or below market, and other related party transactions that likely occurred at non-market rates.

Adjustments may also be necessary to place a financial statement in conformity with generally accepted accounting principles (GAAP). Certain expenses, partially deductible (or not deductible at all) for income tax purposes, should be fully deductible under GAAP. Examples include: meals and entertainment or officer’s life insurance premiums.

The ultimate goal of the adjustments is to accurately reflect the company's financial position as of the valuation date as well as its “normal” results of operations for the periods being analyzed. The goal is not to “correct” the financial statements; rather it is to present them as an outside investor would look at the business.

After normalizing the income statement, you must adjust for any non-cash transactions in the income statement. You must also adjust for any cash transactions not in the income statement. The adjustments will get you to the net after tax cash flow.

Examples of these type of adjustments would include: depreciation and amortization, capital expenditures, and certain principal payments.

When you have made these adjustments to each of the five years statements you will need to average the cash flow from them. Remember that this can be a straight average or a weighted average as discussed above.

After normalizing the financial statement for each of the five years and averaging the resulting cash flow you must then find the appropriate discount or capitalization rate to apply in your business valuation.

How to develop a capitalization rate.

If you had $100,000 to invest you would think about how much risk you were willing to take to get a good return. Someone who didn’t want to risk loosing their investment would find something very safe. Typically that has been Treasury Bills or Treasury Bonds. An investment of this type might yield less than 3 percent.

The lower the risk the lower the return. Too low of a return and you won’t keep up with inflation which is often called a purchasing power risk.

If the investor was willing to take on more risk they might invest in Fortune 500 company stocks. Historically those stocks have earned 12 percent or more. Investing in smaller non-public companies have earned 20 percent or more.

Always remember that this higher return comes with higher risk. Although some have earned these returns, others have lost some or all of their investment.

There are ways to evaluate the risk of a particular company so that you know whether it is a risk you are willing to take on and at what price. The method I most often use doing a business valuation is called the Ibbotson Buildup Method.

The Ibbotson Buildup Method layers different risk estimates on top of each other to build up a discount rate. The appropriate discount rate components are the risk free rate, equity risk premium, size premium and company specific premium.

Morningstar publishes a book annually called the “Stocks, Bonds, Bills, and Inflation Yearbook”. In this book you will find the rates I discuss below.

Risk free rate.

Equity risk premium.

Size risk premium.

The sum of the rates calculated so far give us the average risk factor or discount rate for small businesses similar to the business you are valuing. The next step is to consider the risks associated with the specific company you are valuing.

Specific company risk premium.

If a company rates well in these areas it could require you to lower the overall risk of the company. If a company has shortcomings in some of these areas it may point to a somewhat higher risk.

This is a judgment call and usually requires someone with professional experience to make this determination. I often find these factors adding or subtracting 1 to 5 percent in the buildup of the company’s discount rate.

The overall discount rate or capitalization rate of the company is then the sum of the risk free rate, the equity risk premium, the size premium, and the specific company risk premium. With this information, you can now determine the final value.

How to determine the final value.

If you have done this yourself please remember that someone who is not experienced in how to value a business can make significant mistakes. This discussion was only intended to give you some insight into the process of how to value a business.

I always recommend getting a professional involved in the process of business valuation. If you make a mistake or have a wrong insight due to your lack of expertise and your valuation is off by $50,000 it could be a costly mistake indeed.

There are a number of fly-by-night valuation and internet based companies that claim to know how to value a business. They will do a quickie valuation for you, but don’t go there. Their values aren’t worth the paper they are written on. They don’t visit the company and do the in depth research necessary for a valid determination of value.

There are many business brokers that will apply a rule of thumb for a type of business and give you a value. That’s better than the last group and if you can’t afford a real valuation, it may be a reasonable option when considering how to value a business.

When considering how to value a business, the best option is to hire a professional. It’s worth your time and money to do it right. The cost of a business valuation varies from area to area. In my community a valuation can often be done for $4,000 to $8,000.

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