BUSINESS VALUATION by xiaoyounan

VIEWS: 4 PAGES: 10

									OPERATING PROCEDURE                                                           Page 1 of 10
IPA PROJECT #
SUBJECT:                    BUSINESS VALUATION


1.0   INTRODUCTION

      1.1   The purpose of this Standard Procedure is to introduce the ownership of your
            company to a method of determining the value of your business. With few
            exceptions, the business is the most valuable asset you have. Most business
            people who own a small business want to know how much the business is worth
            even if it is not for sale at the present time. It is wise to start planning for
            succession long before you need to transfer ownership, whether to the next
            generation, to another company or owner.

      1.2   The basic approach of this evaluation method is similar to that used by some
            professional appraisers of small businesses. It assumes that a business is worth the
            value of its assets, plus a premium for goodwill when the earnings are sufficiently
            high. What is unique about this method, is that it establishes a precise format for
            the redefinition of earnings as well as a discipline, through the use of a detailed
            form, so that the method can be followed by anyone familiar with basic business
            accounting.


2.0   THE SEVEN BASIC STEPS

      2.1   The seven steps involved are as follows:

            2.1.1   Determine the Business’ real “Earning Power;”

            2.2.2   Determine the tangible “Asset Value;”

            2.2.3   Determine the “Cost of Money;”

            2.2.4   Determine “Excess Earnings” of the business;

            2.2.5   Calculate a “Multiple” for excess earnings;

            2.2.6   Calculate the “Value” of the excess earnings;

                                   to

            2.2.7   Determine the “Total Business Value.”
OPERATING PROCEDURE                                                             Page 2 of 10
IPA PROJECT #
SUBJECT:                      BUSINESS VALUATION


3.0   CALCULATION OF THE BUSINESS VALUE:

      3.1   Real Earning Power - Calculate the “real earning power” of the business by
            preparing a stabilized (real earning power of the business over a 12-month period
            beginning on the date of valuation) income statement.

            3.1.1   Real earning power is defined as what you think earnings will be over a
                    twelve-month period beginning on the date of valuation. Do not simply
                    estimate your entries that may have been distorted by such factors as
                    accounting techniques used or the non-recurring circumstances that have
                    affected earnings.

            3.1.2   This stabilized or adjusted earnings figure cannot be based on wishful
                    thinking or used to disguise basic problems in a business.

            3.1.3   This statement of real earnings power must be scrutinized carefully in the
                    event of an actual sale or transfer, and is best if all the assumptions used to
                    adjust income and expenses are stated in writing in the evaluation.

            3.1.4   Chart B-100-1 shows a summary of reported earnings for a fictional
                    company along side the stabilized earnings.

                    3.1.4.1    At the bottom of the chart are notes that explain why
                               adjustments were made (these may at times be supported by
                               other documentation for clarification when necessary).

                    3.1.4.2    Adjustments include:

                               1) Replacing owner’s salary, with an owner’s salary based on
                                  what it would cost to hire a manager to replace them;

                               2) Depreciation expense, an item that is often misleading, is
                                  replaced with an expense called “replacement fund.” (Think
                                  of this as a sinking fund to build savings to provide for
                                  normal replacement as equipment wears out.);

                               3) The stabilized earnings, do not reflect interest expense,
                                  since interest expense can fluctuate according to the loan
                                  structure and special circumstances of the owner. Instead,
                                  at a later stage, the term “cost of money” will be defined
                                  and used.
OPERATING PROCEDURE                                                           Page 3 of 10
IPA PROJECT #
SUBJECT:                    BUSINESS VALUATION


     3.2   Asset Valuation - To calculate the value of tangible assets properly, a
           well-qualified appraiser may be needed.

           3.2.1   This appraisal will cover the value of land, buildings, inventory,
                   furnishings and equipment of all types needed to conduct business.

           3.2.2   Chart B-100-2 summarizes the value of tangible assets of your fictional
                   company.

     3.3   Cost of Money - The term, as used here, is a specialized term defining the annual
           investment cost of owning tangible assets of the business. It is a substitute for
           interest expense.

           3.3.1   The rate used may differ from the current prime rate to the actual rate paid
                   depending on the circumstances. If you were to base the valuation on the
                   prime rate, it would lead to a situation where business values went up and
                   down as wildly as the prime rate does, and the business “market value”
                   just does not work that way.

           3.3.2   Therefore, use a figure that is more stable and somewhat lower than the
                   prevailing interest rates. This is the underlying interest rate.

           3.3.3   To keep it simple, a rate about four points above the inflation rate is
                   generally used in these instances. In the illustration, 12% is being used.

                   ***NOTE: The cost of money only applies to the tangible assets of the
                   business, as calculated in Step 2.

                   (Chart B-100-3 shows this calculation for the fictitious company.)

     3.4   Excess Earnings Calculation - The excess earnings represents how much the
           business can be expected to earn after the cost of money is deducted from the
           stabilized earnings.

           3.4.1   Excess Earnings is a simple calculation shown on Chart B-100-4.

     3.5   Excess Earnings Multiple - The excess earnings multiple must be appropriate for
           the business.

           3.5.1   Excess Earnings Multiple will be used in the following step to determine
                   the value to place on the excess earnings calculated above.
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IPA PROJECT #
SUBJECT:                     BUSINESS VALUATION


            3.5.2   This multiple reflects the risk, stability, and other factors inherent in the
                    business.

            3.5.3   Chart B-100-5 is the tool to be used to arrive at the correct “Excess
                    Earnings Multiple” for the business.

            3.5.4   Chart B-100-6 shows the use of the “Excess Earnings Multiple.”

      3.6   Total Business Value - The total business value is determined by adding the
            “Value” assets to “excess” earnings.

            3.6.1   Chart B-100-7 shows the calculation for “Total Business Value.”


4.0   CONCLUSION

      4.1   The steps above, if followed carefully, offer a common sense approach to
            determining the value of any business.

      4.2   Estimating the business value quantitatively determines that a business may be
            worth the market value of the assets that are necessary to conduct business, plus a
            premium if the business is profitable.

      4.3   Upon closer examination it may be observed the methodology used to determine
            the premium to be paid for earnings is quite conservatively calculated.

            4.3.1   In the example used, a multiple of 3.9 was calculated. This means that if
                    the business sold at the same price as the valuation suggests, the purchaser
                    will receive a return on investment of 25.6% on the portion of the purchase
                    price not backed up by tangible assets (payback in 3.9 years equals an
                    annual return of 25.6%, $121,680 divided by 3.9 = 31,200, 31,200 divided
                    by 121,680 = 25.6%).

            4.3.2   There may be a situation that a current business has no excess earnings. In
                    such a case, the business is only worth the value of the tangible assets.

            4.3.3   In fact, some businesses have negative earnings, which means they are not
                    even worth the value of the assets.
OPERATING PROCEDURE                                                            Page 5 of 10
IPA PROJECT #
SUBJECT:                       BUSINESS VALUATION




                                    TABLE OF CHARTS


                        Chart B-100-1     Stabilized Income Statement

                               Actual               %       Stabilized (12 months)       %
                                1996                                1996

Sales of (1)                 $650,000               100.0          $700,000              100.0

Cost of Goods (2)            <197,600>              30.4           <212,800>              30.4
Direct Labor (2)             <187,000>              28.8           <201,600>              28.8

Gross Profit                 265,400                40.8           285,600                40.8

Sales Expense*               < 86,750>              13.3           <92,400>                   13.2
Admin Expense*               < 52,650>               8.1           <42,000>                    6.0
Executive Salaries (3)       < 40,000>               6.2           <49,000>                    7.0
Replacement (Deprec) (4)     < 11,700>               1.8           <21,000>                    3.0
Maintenance & Repair*        < 5,200>                0.8           < 7,000>                    1.0
Misc.*                       < 5,200>                0.8           < 7,000>                    1.0

Total Overhead Exp.          <201,500>              31.0           <218,400>                  31.2

Assumptions:
     1 - Sales will increase at inflation rate of 7.7%
     2 - Cost of Goods and direct labor will remain at constant %
     3 - Executive salary should be increased by $9,000 to reflect current salaries offered in
        comparable businesses.
     4 - Replacement fund of $21,000 will be submitted for depreciation expense. This is
        ample to replace assets as they wear out.
     * - Minor adjustments were made through a detailed analysis of each line item or
        expense and reflect best estimates.
OPERATING PROCEDURE                                                    Page 6 of 10
IPA PROJECT #
SUBJECT:                  BUSINESS VALUATION




                      Chart B-100-2 Value of Tangible Assets

                      Land                             $      20,000
                      Buildings                              120,000
                      Inventory                               60,000
                      Equipment                               60,000
                      Working Capital                         40,000

                      Total Tangible Assets            $     300,000




                             Chart B-100-3 Cost of Money

                   Value of Tangible Assets           $300,000
                   “Underlying” Interest Rate          12%
                   Cost of Money                       $ 36,000



                          Chart B-100-4    Excess Earnings

           Stabilized Earnings (from Chart B-100-1)                $ 67,200
           Cost of Money (from Chart B-100-3)                      <36,000>

           Excess Earnings                                         $ 31,200
OPERATING PROCEDURE                                                            Page 7 of 10
IPA PROJECT #
SUBJECT:                       BUSINESS VALUATION


                               Chart B-100-5     Rating Formula

                       (showing values for the example - see Chart B-100-8 for details)

                       Risk                                  4.0
                       Competitive Situation                 3.0
                       The Industry                          3.5
                       The Company                           5.0
                       Company growth                        4.0
                       Desirability                          4.0

                       Total                                23.5

                       Excess Earnings Multiple (Total/6)      = 3.9



                          Chart B-100-6     Valuing Excess Earnings

                         Gross Earnings (from Chart B-100-4)       $31,200
                         Multiple (from Chart B-100-5)                  3.9

                         Value of Excess Earnings                  $ 121,680




                            Chart B-100-7      Total Business Value

                 Value of Assets (from Chart B-100-2)*                   $ 264,000
                 Value of Excess Earnings (from Chart B-100-6)             121,680

                 Total Business Value               =                     $ 391,920


*Note that the $40,000 used in chart B-100-2 for required working capital has not been included
here. A new owner will have this amount available in addition to the purchase price.
OPERATING PROCEDURE                                                       Page 8 of 10
IPA PROJECT #
SUBJECT:                  BUSINESS VALUATION



                      Chart B-100-8 Calculating the Multiple
                                (key to rating scale)

           RISK RATING: 0-6

                 0 = Continuity of income at risk
                 3 = Steady income likely
                 6 = Growing income assured

           COMPETITIVE RATING: 0-6

                 0 = High competitive in unstable market
                 3 = Normal competitive conditions
                 6 = Little competition in market, high cost of entry for new competition

           INDUSTRY RATING: 0-6

                 0 = Declining industry
                 3 = Industry growing somewhat faster than inflation
                 6 = Dynamic industry, rapid growth likely

           COMPANY RATING: 0-6

                 0 = Recent startup, not established
                 3 = Well established with satisfactory environment
                 6 = Long record of sound operation with outstanding reputation

           COMPANY GROWTH RATE: 0-6

                 0 = Business has been declining
                 3 = Steady growth, slightly faster than inflation rate
                 6 = Dynamic growth rate

           DESIRABILITY RATING: 0-6

                 0 = No status, rough or dirty work
                 3 = Respected business in satisfactory environment
                 6 = Challenging business in attractive environment
OPERATING PROCEDURE                                                         Page 9 of 10
IPA PROJECT #
SUBJECT:                  BUSINESS VALUATION


                 RATING FORMULA

           Risk + Competitive Situation + The Industry + The Company + Company
           Growth + Desirability = Excess Earnings Multiple is the "Total"/6


                             FICTITIOUS COMPANY

     BUSINESS VALUE ESTIMATION

     A     -     Sales for the Next 12 Months                           $

     B     -     Operating Expenses Including Cost
                 of Sales and Direct Labor:

     C     -     Administrative Expenses (do not
                 include owner's salary, depreciation or interest)

     D     -     Owner's Salary (what it would
                 take to hire someone)

     E     -     Replacement Fund

     F     -     Stabilized Earnings

     G     -     Value of Assets Plus Necessary Working Capital

           1     -Land
           2     -Building
           3     -Inventory
           4     -Equipment
           5     -Furnishings & Fixtures
           6     -Other Tangible Assets
           7     -Working Capital Required

     H     -     Total Assets & Working Capital

     I     -     Underlying Interest    (current inflation rate + 4%)

     J     -     Cost of Money
OPERATING PROCEDURE                                                             Page 10 of 10
IPA PROJECT #
SUBJECT:                       BUSINESS VALUATION


       K       -      Excess Earnings
                      (Stabilized Earnings - Cost of Money)

       L       -      Multiple (from Chart M-408)

       M       -      Value of excess Earnings:

               1      -Reenter Excess Earnings
               2      -Reenter Multiple
               3      -Value (Line M1)(Line M2)

       N       -      Total Business Value :

               1      -Reenter Asset Value
               2      -Reenter Excess Earnings

               3      - Business Value (N1 + N2)




Note: If this figure is used by purchasers, they will have to provide any extra working capital to
operate the business. The total business value as shown here includes inventory. This figure does
not apply to stock purchase. The stock purchase value will be this figure (N-3) less total
liabilities to be assumed. In addition, other adjustments may need to be made in the event of a
stock sale if tax benefits are lost as a result by the buyer.

								
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