With few exceptions our business is our most important asset. Most of us who own a successful small business have important reasons for wanting to know how much it is worth, even if it is not, at present, for sale. It is wise to start thinking about and planning for succession long before you need to transfer ownership – whether to the next generation or to another company.
In most industries, there are frequently used formulas that may help you to figure the rough value of your business. For instance a motel may be worth three time’s present annual room income. An accounting practice may be worth from 2- to 3-1/2 times retained annual fee income. A contract metal-working company may be worth book value of assets plus one year’s earnings. Such formulas are useful starting points but virtually useless for marketplace valuation. Recognize them for what they are – rough indicators for an “average” business in a given industry.
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 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.
In summary, the following are the SEVEN BASIC STEPS in preparing an accurate valuation of your business:
Follow the seven steps in formulation:
1. Calculate the “real earning power” of the business by preparing a STABILIZED INCOME ACCOUNT. Real earning power is defined as what you think earnings will be over a 12-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, nonrecurring circumstances that have affected earnings positively or negatively, and so forth. This “stabilized” or “adjusted” earning figure cannot be based on wishful thinking used to disguise basic problems in a business (such as chronically high cost of production due to inefficiencies). This statement of real earning power will be scrutinized carefully in the event of an actual sale, and it is best if all the assumptions used to adjust income and expense entries are stated in writing in the evaluation.
Chart 1 shows a summary of reported earnings for a real coffee shop chain alongside the stabilized earnings. At the bottom of the chart are notes that explain why the adjustment were made (in a careful evaluation, the notes will be much more detailed, and possibly support by other data, depending on the purpose of the valuation).
Other adjustments include replacing owner’s salaries – which fluctuate greatly in real-life circumstances – with an owner’s salary calculation based on what it would cost to hire a paid manager. Depreciation expense, an item that is often meaningless in past financial statements, is replaced with an expense called “replacement fund.” Think of this as a sinking fund sufficient to build savings to provide for normal replacement as equipment wears out.
Note that stabilized earnings do not reflect interest expense, since interest expense can fluctuate according to the structure and the special circumstances of the owner. Instead, at a later stage we use a “cost of money” calculation following the procedure outlined below.
2. Calculate the VALUE OF ALL TANGIBLE ASSETS. A well-qualified appraiser may be needed to do this. This appraisal will cover value of land, buildings, inventory, furnishings, and equipment of all types needed to conduct the business. Chart 2 summarizes the value of tangible assets of the company we are using for an illustration.
3. This step involves determining the COST OF MONEY. As used here, it is a specialized term defining the annual investment cost of owning the tangible assets of the business (as defined in step 2). It is a substitute for interest expense. The rate used may differ from the current prime rate or the actual interest rate that may have to be paid under any particular set of circumstances. If we were to base the valuation process on prime rate, it would lead to a situation where business values went up and down as wildly as the prime rate does; and the market just doesn’t work this way. So we settle on a figure that is somewhat more stable. It is also somewhat lower than prevailing interest rates when most of the assets involved offer considerable tax shelter, as they do in this example. This may be called “the underlying interest rate.” To keep it simple, we generally use a rate that is about four points above the inflation rate. At present, we are using a rate of 15%.
This “cost of money” figure applies only to the tangible assets of the business as calculated in step 2. Chart 3 shows how we have made this calculation in our example.
4. This step is to determine a figure that we call EXCESS EARNINGS. This figure represents how much the business can be expected to earn after the cost of money (as defined in step 3) is deducted from stabilized earnings (as defined in step 1). It is a simple calculation, as shown in Chart 4.
5. This step is to determine an EXCESS EARNINGS MULTIPLE that is appropriate for the particular business being examined. This multiple will be used in the following steps to determine what value to place on the excess earrings as calculated in step 4. This multiple reflects the risk, stability, and other factors inherent in the business. Chart 5 is the tool we use to arrive at a correct multiple. It incorporates in shorthand, the basic values that the market places on the quality of earnings of a particular company.
6. The multiple developed above will be used with the excess earnings figure, as shown in chart 4.
7. Finally, in step 7, we are in a position to determine the total value of the business. We do this by adding the value of the assets (chart 2) to the value of excess earnings (chart 6). The steps above, if followed carefully, offer a commonsense approach to valuation. They suggest (accurately) that business is worth the market value of the assets that are necessary to conduct the business, plus, where appropriate, a premium if the business is especially profitable. A closer examination will reveal that the methodology used to determine the premium to be paid for particularly high earnings is quite conservatively calculated. In the example used above we arrived at a multiple of 2.0. This means that if the business is sold at the same price as the valuation suggests, the purchaser will receive a return on the investment of 50% on the portion of the purchase prices that is not backed up by tangible assets (playback in 2.0 years equals an annual return of 50.%).
“Negative” excess earnings. Any business may have no excess earnings. In this case, the business is likely to be worth no more than the value of the tangible assets. After all, a seller cannot expect to charge a premium (known in accounting terms as “goodwill”) if the business cannot generate more than enough funds to pay for the assets. In some instances the figure arrived at the excess earnings may be a negative or minus figure. In such a case, the business is not even worth the value of its assets, and the best course may be to liquidate. Every business is unique, and these comments must be qualified according to the circumstances of each. An example would be the business that provides an exceptionally nice lifestyle for a retired couple – in a sense, a combined part-time job, home, and hobby. Placing value on such a business is quite difficult and subjective. How much is that lifestyle worth? This article will not solve that problem. However, this method will be helpful in understanding some of the basic principles on which an agreement might be reached.
Summary: In all probability, an owner who follows this approach carefully and objectively will arrive at a conclusion of value that is quite close – within 5% to 10% – of what the business should sell for, given adequate time and effort to find a qualified, arm’s-length purchaser.
It will be obvious that many of the steps involved will require quite a bit of knowledge and judgment about the particular business being examined. For example, a buyer and a seller, each using this method, may arrive at quite different opinions of the rating to be used for something as intangible as the “desirability” of a particular business
However, if the method is followed closely, differences in judgment will generally lead to quite small incremental differences in overall value. Perhaps even more important is the process of getting all these judgments, opinions, and assumptions written down in the disciplined form we have followed here. Then a buyer and a seller (if they are not playing games with each other) can compare all of the instances where these judgments differ. This leads to a very important discovery – that when the negotiations and discussions relating to a purchase and sale are focused on particular, defined items, it is usually not difficult to reach agreement. A buyer and seller should discuss the differences in such judgments and should arrive at a middle ground. Often, this is the only way to arrive at the facts behind a particular assumption.
Effect of terms. Finally, the actual price to be paid for a business will often differ considerably from its value as defined here if there are special terms available as part of the transaction. For example, it is worth paying a much higher price thpan indicated if a very low interest rate is available, the owner will carry a lot of “paper,” etc. As a rule, a little work and help from a qualified CPA will help to place a value on the benefits of such special terms. Then, a correlation between the value as indicated by this method and the value of the special terms can be established, and appropriate adjustments made.
The real problems that generally arise in negotiations are usually emotional ones. One party does not trust the other. Opinions of one party are so vague and general that they arouse suspicion. Such problems will almost always arise unless a careful, step-by-step approach to valuation such as this one is followed.
by Patrick R. Davidson, MBA | Business Consultant and Wealth Coach, Provident Financial Services