The most obvious reason for having your business valued is because you want to sell it. Consequently many business owners assume that if they are not planning to sell the company, it’s not necessary to know its value.
But there are other times when you should know the value of your company such as when planning for its future, applying for bank loans or establishing tax liability.
If you are the owner or a partner in a closely held business, assessing the value of your company may not be simple. Unlike public companies, whose values are determined partially by the forces of the market, closely held businesses must look to factors such as normalized income, cash flow and assets.
A normalized earnings statement is one way to present an accurate picture of the operating performance of your company.
A typical earnings statement reflects all the financial activities of a business for a given year or period. In addition to income and expenses related to operations, it takes into consideration the specific actions of the owner or owners, outside investments and other activities not related to the business itself and non-recurring events.
In other words, income statements in themselves don’t necessarily reflect the company’s ability to grow or generate future income.
The compensation that owners pay themselves, for example, may or may not reflect the fair market value of their services. It’s not unusual for owners to compensate themselves with company earnings rather than drawing a salary, and this lack of objectivity in the area of compensation means that income statements may not reflect the actual value of the owner’s services.
Therefore, during the normalization process, the owner’s value to the business must be assessed objectively. Do the owners bring unique benefits to the future of the business? What compensation would be needed to replace them?
Other important considerations: Does the business rent equipment or facilities from the owners? Are there retired stockholders receiving dividends? What fringe benefits does the ownership receive?
Frequently, a business generates income that is not tied to its operations. These items are removed when normalizing earnings statements. Examples include income from real estate not currently being used by the business, or income from securities and investments not tied to operations.
On the expense side, if a company has invested a significant sum in new-product development or employee training that is not expected to pay dividends in the short term, the investment should probably be capitalized and amortized.
Among the most common items to appear in company earnings statements are non-recurring income and expenses. These are generally the result of unique events, rather than ongoing operations, and therefore should not be included in normalized earnings statements. These may include damage because of natural disaster or the settlement of a lawsuit.
Using cash flow to value a business allows the owners to assess current business strategies. You can also use cash flow to determine shareholder value because it indicates funds available for pay-out to creditors and stockholders.
Whether a company is closely held or public, the shareholder value can be determined by subtracting debt from corporate value. Corporate value is made up of three components: present value of cash flow, residual value, and current value of liquid investments.
Computing future cash flow takes into account past sales, the rate of sales growth, operating profit margins, the cash income tax rate, the incremental fixed capital investment rate and the working capital rate.
There is no set formula for figuring the residual value of a business. It must be looked at in terms of the market and the competitive stance of your business.
There are a number of different cash flow methods for valuing a closely held business. One, the discounted cash flow method, projects future earnings.
The discounted cash flow takes the sum of the company’s future annual cash flows discounted at a rate equal to the risk of the investment. This is done for each projection period, and the totals are added to the value of the residual to determine estimated future earnings.
Companies that use equipment and machinery as revenue-generating tools must value those assets to have a true picture of their worth. There are a variety of methods for appraising tangible assets, and the approach used for a specific business generally depends on why the valuation is being done.
For example, if you are valuing your business in preparation for a bank loan, you will need to know the market value of the equipment, the orderly liquidation value and the forced liquidation value. If you are interested in obtaining insurance, you will want to know the replacement value of your machinery and equipment.
So far, I have focused the valuation process on earning capacity and tangible assets. However, to get a truly accurate measure of a company, other factors must be taken into consideration.
Intangibles are also an important component of many businesses and should be taken into account during a valuation. The existence of goodwill or an extensive customer list may increase a company’s value. Advertising, conscientious customer relations and the reputation of your product or service must also be evaluated.
Lewis Sharpstone, CPA, CVA, is partner-in-charge of the business valuations division of Westwood-based accountancy, Singer Lewak Greenbaum & Goldstein LLP.
Entrepreneur’s Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact Dan Rabinovitch at (213) 743-2344 with feedback and topic suggestions.
