Owning Your Own Business: Business Valuation

Introduction

Determining the value of a business, particularly for purposes of buying or selling it, is not an exact science; there is considerable art included. There is no secret formula that applies to all companies or even to the same company at different points in time, and any quantitative approach must be supplemented by good judgment and common sense. The information that follows represents an overview of business valuation and is not intended to be all-inclusive; therefore, it is essential that buyers and sellers employ the advice of qualified professionals.

Purposes

It is important to develop a well-founded value for a business in a variety of circumstances:

• When buying a company, in order to not over-pay.

• When selling the company, in order to receive full value.

• When selling a portion (e.g., shares) of the company, in order to receive (and give) fair value.

• When preparing estate and succession plans.

General Approaches

There are two general approaches, as well as combinations of the two:

Asset-Based Valuation

Asset-Based valuation is complicated by the fact that the value of most businesses consists of balance sheet assets, both tangible and intangible, as well as other assets that donít appear on the balance sheet. A business asset is anything the business owns that has value, like cash in a bank account, buildings, property, machinery, office equipment, work in process, inventory, accounts receivable. Both types of assets must be evaluated in order to arrive at a value for the total business.

Balance Sheet Assets

There are a number of components to consider, each of which requires a slightly different approach, as indicated below:

• Accounts Receivable
• Delete those receivables that are old and probably not collectable.
• Discount those that are probably not fully collectable or which are not 100% certain.
  
  Inventory
• Delete material inventory and finished goods inventory that is scrap or obsolete.
• Reduce the value of inventory (especially finished goods) that will have to be discounted, in order to be sold in the future.
• When buying a business, eliminate inventory that doesnít fit into future plans.
  
  Fixed Assets (Buildings, Machinery, Equipment, Vehicles)
• Determination of the value of these assets might require the assistance of a professional appraiser.
• The book value of fixed assets is not a good indication of their value and should not be utilized.
  
  Liabilities
• Liabilities must usually be paid in full, so they should be deducted from the assets to arrive at an adjusted net worth if they are part of a business purchase/sale negotiation.

Non-Balance Sheet Assets

This group of assets is often the most valuable facet of a business. As a group they are generally referred to as goodwill and usually consist of the following:

Customers
Suppliers
Location
Reputation
Employees
Procedures / Ongoing Operations

By their nature, these assets are difficult to value and there are many approaches that can be utilized. Generally, their valuation must be based on logic and common sense, as well as an understanding of the business.

---

Income-Based Valuation

This approach is even less precise that the Asset-Based approach because it is based on projections of the net profits and cash that the business will be able to generate in the future.

Despite its inherent lack of precision, Income-Based valuation is highly preferable and can be utilized alone or in combination with Asset-Based valuation. The preference for this approach is based on the fact that the value of the business to a buyer stems from the future stream of cash flow that can be generated by the business. Future cash flow will represent the return on the investment in the business and it this return must be adequate to justify the investment.

This approach utilizes the fact that a dollar received next year has less value than a dollar received today, and a dollar received five years from now has substantially less value. In addition, the value of future dollars becomes lower as the current return on other investments increases. This is the concept of Net Present Value.

For example, if you can make 5% on a Certificate of Deposit or 10% in the stock market, you will probably want to make at least 20% from the investment in a business, due to the higher inherent risk. In other words, investment in ownership of a business will usually command a significant premium over a safe investment.

Utilizing the concept of Net Present Value, each future yearís cash flow is discounted by the desired rate of return, say 20%. Usually cash flow is projected and then discounted for each of the next five years; the sum of these discounted cash flows represents an estimate of the net present value of the business. In other words, a buyer should expect to pay (and a seller should expect to receive) the net present of the business.

---

Combinations of Asset-Based and Income-Based Valuations

There are a number of ways in which these approaches can be combined, but the most important way is to use one of the approaches to verify the reasonability of valuation based on the other.