Technical Reference Bulletin No.101 Realistic Business Valuation ave you heard that you can multiply your current earnings by 5 (or some other number between 3 and 8) to calculate the value of your business? Unfortunately, merely looking at last year’s financial statement and making an estimate is often incorrect and misleading. A realistic business valuation requires a thorough analysis of several years’ of the business operation, application of quantative methods and an opinion about the future outlook of the industry, the economy and how the subject company will compete. What is fair market value? IRS says it is “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. “ This is found in Rev. Ruling 59-60, written for the purpose of assessing estate, gift and other taxes. I believe . . . the IRS meant to say a “hypothetical” buyer. Under this concept, fair market value would assume no knowledge of a structured purchase transaction that may involve It is a tax benefits, favorable interest rates and terms in a seller financed transaction. It is a "hypothetical" “hypothetical” selling price. The IRS ruling does not assume that a willing transfer of selling price ownership is even contemplated. What information is needed to value a business? First item on the agenda is to identify the purpose of the valuation. Valuation for purposes of divorce (partners included) or to satisfy ESOP requirements may produce different results than valuation for negotiating the sale of a company. For example, the split of a company into two may require analysis of the increased risk. This may result from a division where one business is left with a leaner capital structure than that of historical operation. In other words, the previous sales level at this division is not readily achievable as a stand-alone company. In this example, the value of the two parts may not add-up to the value of the company as a whole. For the purpose of discussion, let’s assume that the objective of the business valuation is to aid in negotiations to divest the company. Remember the “garbage-in” “garbage-out” phrase? Care must be taken to gather complete and accurate information before commencing the business valuation. Some of the analyst’s information needs include: • Industry and market share information • Receivable aging • Five years financial statements and tax returns • Inventory list • Corporate/ownership structure • Pending litigation • Asset depreciation schedule • Employment/union contracts • Property and equipment leases • Owner compensation Let's look at some valuation techniques n general, there are three basic types of So, let’s quantify some expected returns . . business valuations; For early stage startups venture capitalists seek a 1 - Asset based projected annual rate of return of 60% to 70% 2 - Cash flow based & with the expectation that one in 10 investments 3 - Public market based techniques will succeed. This high rate of return is matched Revenue Ruling 59-60 advocates finding a with an equally high rate of risk of losing your comparable publicly traded business to apply a investment. According to Ibbotson Associates, comparable business factor. It is difficult if not well known for their analysis of statistics, the unlikely that in large publicly traded company corporate stock investor has earned an average could be found that has the same product mix, return of 10.3% a year since the end of 1925. distribution system and market as a small, The risk associated with investment in an closely-held business. If one were found, established closely-held business is somewhere adjustments would be required to account for between the venture and the larger publicly-held differences in financial stability and depth of business investment. Assessment of the traits of management. the subject company will reveal a quantifiable risk Generally, public market based techniques are factor and capitalization rate that can be applied ruled out in favor of computing the value of a to the earnings of the company. business based upon the asset value and It should be noted that general economic capitalized cash flow produced by the business. conditions affect the value of a business by When appropriately applied, these formulae will increasing or decreasing the optimism for future compute a range of possible values. profits. As the climate changes, the degree of In my opinion, the most accurate method to risk also changes and capitalization rates are the correct value assess the value of a closely-held company is a appropriately altered. Thus, the value of many of a business is an capitalization of earnings. small companies today may be no more than amount that produces 65% to 75% of what it was in the 1980's. a sustainable rate of But what earnings? return that is equitable To the extent that future earnings can be In Summary for the risk confidently projected they will theoretically The valuation of a business is truly an art rather produce the most accurate value of the than a science. There is no precise, irrefutable business. Unfortunately, projecting future “correct answer.” Only an “opinion of value” or economic conditions, future interest rates, rational basis predicated on the application of the unwritten tax benefits or assessments and other generally accepted valuation principles and the assumptions often erode the reliability of future experienced judgment of an evaluator. earnings estimates. And what capitalization rate? Capitalization rates usually include inflation and an appropriate return for risk. About the author: At Business Exchange Center we believe that Lori King, CPA CBC is a principal in the Bellevue, the correct value of a business is an amount Washington based business valuation and divesti- which produces a sustainable rate of return that ture firm, Business Exchange Center, Inc. is equitable for the risk to be assumed. Exchange is a publication of: Business Exchange Center, Inc. 10655 NE Fourth St., Suite 601 Bellevue, WA 98004 Ph. 425.635.0454 "Profitable Businesses for Qualified Buyers"