It is not a game for amateurs A current business valuation should be a high priority. It is necessary to establish a stock price for business transactions such as sales, buy/sell agreements, mergers or acquisitions, dissolutions including liquidation or bankruptcy, estate planning, and raising equity. You can even use it to defend a minority stockholder claim or to fight an eminent domain land grab by government authorities.
If you are selling, raising equity capital, liquidating or settling with creditors or vendors, you will want a high valuation. The opposite is true for those who are buying a company or doing estate planning or gifting.
There are several common approaches to valuation. A market approach measures the worth of your company against several comparable public companies. Financial buyers use the income approach, which is based on discounted future financial returns. The cost approach, which is seldom used, measures the replacement cost of assets, adjusted for depreciation and obsolescence. Based on the presumption that some businesses are worth more “dead” than “alive,” it is often used by liquidators.
Privately held businesses are particularly difficult to evaluate, since there are seldom any equivalent public companies available to use as comparables. Issues related to minority shareholders, indirect ownership by family limited partnerships, dependence on a single key manager, and limited access to capital can produce a wide range of price calculations.
During the valuation process, you will be providing information on company history, the experience and capabilities of owners and managers, current buy-sell agreements, and existing pension plans. Your operations will be thoroughly analyzed, including your customers, market niches and their relative profitability, employees and their skills, asset ages and values, and new business development strategies. Financial analysis will be based on at least five years of balance sheets and income statements, and some “recasting” will be done to address hidden assets or liabilities, inflated owner perks and variable revenue or growth cycles. Finally, your company trends will be compared to those in the entire industry.
Several methods may be used to arrive at a final price for each share of stock. A firm or agreed price is often established for buy/sell contracts, such as stock repurchases or buyouts between family members or partners, using a formula that is recalculated each year. Some methods are based on asset value. For example, tangible book value uses the net worth of the business (assets minus liabilities) from your last balance sheet, and adjustments are made for intangible items such as good will and deferred costs of financing. The share price is based on that number divided by the total number of stock shares. Adjusted tangible book value makes further adjustments to asset values.
Other methods are based upon earnings instead of assets. Multiple of earnings uses the net income from last year, multiplied by a price-earnings calculation (1 ÷ capitalization rate). Capitalization rates typically range from about 5 percent for businesses with excellent growth rates to about 15 percent for those with more typical growth rates. Again, this value is divided by number of shares to get the final share price.
Financial investors use the discounted future earnings method to calculate future earning power (often perceived as the real value of a business). The assumption is, due to inflation, a dollar earned in the future is worth less than the same dollar earned today. Future earnings are projected for 5 to 10 years, and discounted using a net present value (NPV) rate, then totaled, and this number is compared to an investor’s targeted return on investment (ROI).
The discretionary cash value method assumes the business is only worth what it earns for the owner, such as salary, perks and expected return on investment. This number is converted by subtracting any installment debt and adding the buyer’s target ROI and down payment. The final number should be the price the buyer is willing to pay.
Using the liquidation method assumes that the business ceases to operate, sells its assets, pays off liabilities, then distributes the remaining value to owners in proportion to their stock ownership. This method establishes the absolute bottom value possible.
Finally, the replacement value method assumes many assets are undervalued on the balance sheet due to inflation and depreciation and adjusts them upward. The formula combines several of these methods (for example, 25 percent tangible book value, 50 percent multiple of earnings and 25 percent discounted future earnings), and this kind of analysis is often used in a sale to a larger company.
Valuation is useful not only for transferring a business but as a tool to measure overall company performance. The final value depends on the methods used and the purpose for which the analysis is performed. It must be accepted by key stakeholders and withstand the scrutiny of the Internal Revenue Service.
No matter which method you choose, hire a qualified professional. Doing your own business valuation is like removing your own appendix—it’s not a game for amateurs.