How much is your business worth?

HOW MUCH IS YOUR BUSINESS WORTH?
By Nevin Sanli
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Determining the value of a business is one of the most
complicated and most crucial tasks. The question “How much
is your business worth?” is often asked in times of
transition and great uncertainty. The decisions taken based
on the valuation can have serious consequences.

A business valuation is needed when:

· a partner or shareholder wishes to buy-out other partners
or shareholders;

· an individual or a business contemplates a merger, sale or
acquisition;

· litigated matters such as shareholder disputes, divorce,
and breach of contract require expert witness testimony on
business valuation issues;

· estate and gift taxes must be determined upon the death of
a shareholder or owner of a business or upon gifting of an
interest to family and friends; and

· taking of property by the government causes damages to a
business.

Some of the more esoteric business valuation assignments
include the valuation of businesses for privatization; the
analysis of the potential proceeds, if any, of an initial
public offering (IPO); anti-trust litigation; trademark,
trade name and patent infringements; the valuation of
intangible and stand-alone assets; and relocation impact
studies.

Business valuations consist of determining the value today
of a business’ future earnings potential and the risks
(threats) of those future earnings. One must forecast future
earnings and assess risk. Earnings forecasts depend on the
industry and the economic outlook for the business’
products, current and future competition, projected changes
in demand, and the business’ capacity to grow in light of
its past financial and operational performance. Risk factors
include the business’ financial condition (profitability,
cash flows, and ability to pay debt), management’s ability
to sustain operations and profitability, market and industry
trends and outlook, competitive forces, the economic
environment, legal and regulatory issues, and contingent
liabilities. Forecasts and risk assessment require in-depth
research and analysis, and due diligence. Access to and use
of innovative research techniques (telephone surveys,
library research, field studies, product sampling and
testing, and industry and competitive research) and
information technology (on-line databases and the Internet)
are imperative. Effective and reliable valuations depend on
excellent research and creativity.

There are two primary valuation methodologies:

The First Method is the discounted future earnings method.
It calculates the value today (i.e., discounted for time) of
the business’ earnings in the future. One must forecast
revenues, expenses, profits and cash flows. As indicated
above, the appraiser must carefully analyze all factors
(threats) that can impact a business’ capacity to generate
future earnings. Risk assessment is perhaps the most
important aspect of the analysis. The discount rate, which
is a percentage number usually between 10% and 100%,
quantifies risk. Generally, the applicable discount rate
correlates directly with yields on publicly available
securities such as treasury bills, corporate bonds and
shares of publicly held companies. The higher the discount
rate the riskier the business.

The Second Method is the comparable or guideline company
approach. In this method the appraiser collects data on
recent sales of similar companies and calculates the
valuation multiples (i.e., price to earnings, price to
revenue, price to cash flow, etc.) for each transaction. The
data can be the price per share at the date of value of
publicly-held stock or the terms of publicly announced
mergers and acquisitions. The valuation multiplies derived
therein inherently represent the financial markets’
expectations of future earnings and assessments of risk. The
appraiser analyzes the multiples to determine which ones are
applicable to the subject company.

The key in this approach is the selection of the comparable
or guideline companies. Traditionalists tend to select
companies that are in the same industry, the same
geographical area and are similar in size. Recent research
indicates that it is more accurate to use companies that
exhibit similar financial performance, operate in similar
types of niche markets vis-à-vis their respective
industries, and have similar business and management
philosophies. This more flexible and more fundamental
approach can result in the selection of companies that are
in different industries, are substantially larger in size
and that operate in distant geographical areas. However, the
valuation multiplies derived therein are more applicable to
the subject company. One must assure that any guideline
company used in the final valuation analysis bears some
similar behavioral characteristics as those of the subject
company.

Once a set of usable guideline companies is selected, the
appraiser must adjust the financial statements of these
companies for extraordinary and non-recurring items and for
differences in accounting practice. In addition, further due
diligence analyses must be performed in order to confirm
behavioral characteristics. Some of the limitations of this
method are that it is extremely time consuming and is
usually best suited for businesses with annual sales
exceeding $20 million.

When economically feasible, the appraiser should use both
methods independently. This should yield two values. If the
values are significantly apart, the appraiser should
reevaluate the methodologies, assumptions and data for each
method. However, if upon reevaluation the methods cannot be
reconciled, the appraiser must provide an explanation of the
divergence and the level of confidence in the opinion of
value, if any. In the event that both methods yield similar
values, the appraiser must ascertain that it is not due to
coincidence and that the resulting opinion of value is
robust. Under all circumstances, the appraiser should have a
high level of confidence in the opinion of value.

It is prudent to perform a sanity or reasonableness
procedure to assure that the business’ future cash flows
will cover: 1) the cost of financing the purchase of the
business at the stated opinion of value; and 2) the
projected capital expenditures necessary to sustain
operations and growth.

When a business has been losing money for several years and
should perhaps be closed, the methods above are not
applicable. Instead, one must conduct a liquidation (orderly
or fire-sale) appraisal of the business’ tangible assets,
which include real estate, machinery and equipment, and
inventory. It is preferable to retain qualified specialists
in each of the categories of tangible assets.

With some businesses, liquidation may also involve the
separate valuation of intangible assets such as patents,
customer lists, trademarks, mail-order catalogues, leasehold
interests, proprietary systems and know-how, royalties, film
and record libraries, contracts, and securities (stocks and
bonds). These types of assets usually have stand-alone value
and should be valued under the assumption that they are not
affected by the business’ misfortunes. A variety of
valuation methods which consider furture earnings potential
are used for stand-alone assets. Note that going concern
businesses also own stand-alone assets which must be valued
on a regular basis.

Small businesses, such as restaurants, liquor stores and dry
cleaners, often employ a variety of other methods and
formulas. Typically, these methods are rules-of-thumb and
cannot be supported by sound theoretical foundation.
However small a business may be, it is important that
valuation methodologies that can withstand the scrutiny of a
third party, such as the tax man, are used.