Methods
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There are a number of ways to appraise the value of your business. Four popular methods are briefly discussed below.
Adjusted Book Value
The book value of a closely held business (assets minus liabilities) may have to be adjusted because the assets are usually carried on the books at acquisition cost (land and marketable securities) or at depreciated value (buildings and equipment) rather than fair market value.
Adjusted book value is really an estimate of the liquidation value of your business interest and typically should not be used as a stand-alone valuation method. Because book value neglects the value of goodwill and other intangibles that raise the value of a going concern, it should be used with or as a component for averaging several valuation methods.
Capitalized Income
Capitalization of income is a rather simple yet subjective method for valuing your business. You probably started or purchased your business interest as a means to put capital to work with an anticipated rate of return for your investment. This determination was likely influenced by the relative risk of your business. With a safe business, an expected rate of return may be in the 8-11% range, an average-risk business, 12-17%, and a speculative business, 18% or higher.
Any income your business earns in excess of the expected return may be the product of intangibles such as reputation and market position (also known as goodwill). What a buyer is willing to pay you for that goodwill (the capitalization rate) is influenced by whether your earnings have been stable (7-10 times), variable (4-6 times), or volatile (1-3 times) the excess income.
Comparable Companies
This method is much easier to use when comparing publicly traded companies. When valuing closely held companies, valuation experts usually attempt to find similar companies that have shares traded on the open market. The items that are compared are the price/earnings ratio, price/cash flow ratio, and operating margins. When these comparisons are not available, appraisers will typically look at recent sales of similar types of businesses.
Going Concern Value
The “going concern” valuation method is based on the ability of your company to produce continued earnings. The best guide to future earnings performance is your past earnings performance.
Typically, fives years of profit and loss statements are analyzed to help estimate value. Adjustable items will include any abnormal sales increase or decrease, a one-time capital gain, or an unusual increase or decrease in expenses. When predicting cash flows, five years are forecast into the future with each year being discounted back to the present value. Finally, all the present value calculations are added together to determine fair market value.
Note: It is important to keep in mind that the above are generalizations and your business may fall well outside these parameters for a number of different reasons. Valuation experts, such as your accountant and appraiser, should always oversee the valuation process.
Please contact your legal and tax professionals for more information about this topic.
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