Valuing a Business

Overview

If you're thinking of purchasing or selling an existing business, going public, or taking an investor, one of the first things you'll need to determine is how much the business is worth. Valuing a business is a tricky process and achieving fair market value should always be your top priority. Fair market value is the amount at which the property would change hands between you and the seller when neither of you are under compulsion to buy and when you both have reasonable knowledge of relevant facts concerning the business. But what facts do you need to know? And how can you go about assessing those facts before you set out to acquire the business at fair market value? Generally, there are three approaches to determining fair market value: the income approach, the asset approach and the market approach.

Outline:

  1. Determine potential income
  2. Evaluate important assets
  3. Pay less for less
  4. Compare the market

1. Determine Potential Income

The income approach is generally used when valuing small, closely held businesses. This approach is a general way of determining a value indication of a business, business ownership interest, or security. When using this approach, you can easily determine the value of a business using one or more methods wherein you convert the anticipated benefits of owning the business. For example, we have used the income approach to evaluate the value of a small retail operation.

For purposes of this illustration, we have given the business sales of $120,000, a gross profit margin of $60,000 (or 50 percent of sales) and operating expenses of $35,000. Using these figures, you will first discover that this business has a pretax profit of $25,000. However, it is generally accepted that you start the income approach with the after-tax profit of the business based on corporate tax rates, even if the business is a non-corporate operation.

To find the fair market value, it is then necessary to divide the after-tax figure by the capitalization rate, which is a percentage used to convert income into value. Therefore, the income approach for this subject would reveal the following calculations:  

Pretax Profit $ 25,000
Corporate Tax - 6,000
After Tax Profit 19,000
Capitalization Rate 25%
Fair Market Value $ 76,000 

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2. Evaluate Important Assets

You can use the asset approach to determine a value indication of a business's assets and/or equity interest. This method is based directly on the value of the assets of the business less liabilities. The asset approach is appropriate when the profits of a business are small in comparison to the assets employed to generate that business's profits. In our example, the income approach will be tried first and then the asset evaluation will be done to make sure that the value arrived at using the income approach is greater than the value of the assets owned by the business.

Once you've finished with the income approach, your asset evaluation of our retail study should determine that the fair market value of all the tangible assets such as equipment, furniture, inventory, etc., does not exceed the income indication $76,000. If they do, the asset approach would be more appropriate in determining the value of this company. If this is the case, then the $19,000 in profit would not justify the business's investment in the assets it owns.

Assume that the assets are valued as follows:  

Equipment $12,000
Furniture 7,000
Inventory 25,000
Fair Market Value of Assets 44,000

It is then necessary to factor in the intangible asset which arises as a result of name, reputation, customer patronage, location, products and similar factors that have not been separately identified and/or valued which generate economic benefits. These intangible assets are commonly referred to as goodwill. The goodwill figure in our example was calculated by taking the total fair market value arrived at by the income approach and then subtracting the value of the tangible assets being purchased. Our calculation would then look like the following:  

Goodwill $32,000
Fair Market Value 76,000

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3. Pay Less for Less

In the example shown above, the assumption was made that 100 percent of the business is being sold. If only 30 percent was being sold, you might want to take into consideration some form of minority discount. A minority discount lessens the fair market value for you because you will not have control of the business you are buying. For example, if you would only own 30 percent of the business, the other 70 percent would control the business. In that case, you might not want to pay exactly 30 percent of the value based on what 100 percent of the company is valued. There have been numerous books written explaining how to determine the amount of discount you should take, ranging from 10 percent to 50 percent.

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4. Compare the Market

In addition to considering a minority discount, you should think about a marketability discount. This is an amount or percentage deducted from an equity interest to reflect lack of marketability. It is generally accepted among professional appraisers that the standard for marketability (or liquidity) of minority interests in closely held businesses is cash in three days. In other words, sellers of publicly traded securities with active markets can achieve liquidity on the third business day, at or very near the market price prevailing at the time of the sale.

The market approach is a way you can determine a value indication of a business, business ownership interest or security by comparing the subject to similar businesses, business ownership interests or securities that have been sold. However, for most small businesses finding a similar business that has been sold or finding a publicly traded company similar in many ways to the subject company is generally very difficult. The SIC number on the subject company's tax return is a good place to start in trying to find a company within the same industry as the business being valued. The Internet can be used to locate a 10k of a public company. The 10k statement discloses many of the ratios that should be compared to the subject company being valued.

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