For What It’s Worth
What’s the value of your business?
The question that I get asked the most as an accountant who performs business valuations is how to determine the value of a business. I am usually asked for the “back of the napkin calculation.”
As a business owner, the reasons to obtain a business valuation are numerous. Sometimes they are required for tax purposes or estate planning. Sometimes it is for the business owner to make informed decisions for the future, often to take steps to improve the value of the company, or as part of a buy/sell agreement; or perhaps it is even needed for litigation.
I want to discuss some basic concepts behind a business valuation and why using a certified valuator is important to help mitigate the risk of performing a shoddy calculation, which could have significant negative consequences.
Perhaps the most important concept behind a valuation of a business, or any asset for that matter, is that the value of any asset is the present value of the anticipated future benefits that the asset is expected to generate -- discounted by a rate of return that is reflective of the risk of being able to attain the projected future benefits.
When I use the term “future benefits,” I mean cash flows. There are three main approaches for performing a business valuation, but it all really comes back to anticipated future cash flows: how much will they be, when will they arrive, and how likely is this to happen?
The approaches to business valuation may sound familiar if you have any experience with real estate appraisals. The value can be determined under an asset approach, whereby the company’s underlying assets’ fair market value is determined – this is similar to a cost of replacement approach in real estate. The theory here is that the business owner should at least be able to obtain the fair market value of the entity’s assets, less liabilities, if the cash flows generated in the future do not support a higher value than those of the underlying assets.
The value can be determined using an income approach, which attempts to measure the cash flows projected to be generated by the company (or rents for real estate). These are then discounted back to a present value based on estimated required rates of return (or a discount or capitalization rate).
Determining projected cash flows and a discount or capitalization rate is a complex and delicate process involving numerous inputs. This approach is commonly used for a typical operating company — in other words, a company that is actively engaged in the sale of a product or service and is ongoing. The last approach is the market approach, which involves looking at sales of similar companies (and I mean very similar companies) to derive an estimated value. This is similar to looking at sales comps for real estate.
The approach selected takes careful consideration of the factors at hand and depends on the purpose for obtaining the valuation. No method is inherently better than another, but some are preferred based on the unique circumstances involving your company. The use of a certified professional can be very beneficial to make an informed decision. For one, a certified valuator must adhere to a credentialing organization’s standards, which helps provide comfort that valuation engagements are performed with objectivity and with a level of due diligence to protect the public. If you find yourself working with a valuator that always tells you what you want to hear and not what you need to hear, it could mean that you are not getting the best information to better your business.
A certified valuator will also have the necessary experience and access to useful resources to properly analyze your company and provide you with the answers to your most pressing questions: How do I improve the value of my company? What if I am a minority owner? How do I stack up against my competitors or the industry in general? Do I need a valuation for my parents’ estate? Is it time to sell, or do I need a few years? How do I determine the asking price of my business? Is the offer I received reasonable?
Keep an eye out for my new valuation blog, “For What It’s Worth,” which will be starting soon to touch on some of the most frequent questions I see in the profession. If you are a business owner and find yourself asking any of the questions above, let’s talk and really discuss what it’s worth.
Spencer H. Lamb, CPA, CVA, representative of Business Valuation Consultants, LLC, a strategic association of Heard, McElroy & Vestal, LLC email@example.com, 318-429-2034.