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| Business valuation is a mix of art and
science. The bottom line is, of course, that a business is worth what a
buyer will pay for it. However, there are ways of estimating a fair price.
Several of those methods are described in this section. There are variations
of these and there are other methods that apply to specific situations. It
is not uncommon to value a business by a number of different methods and use
an average (or more likely a weighted average that gives more weight to some
methods than to others) of the various methods used.
Note that there are a number of reasons for valuing a business, other
than buying or selling it. Businesses are valued for estate and tax
purposes, divorce settlements, and for raising capital. In keeping with the
purpose of this web site, all valuation discussion here will be limited to
valuing for buying and selling.
Need help valuing your company? We offer business valuations for a very
reasonable price. Click
here for more information on our valuation services. |
| A common method of valuing a business is
called the Capitalization of Earnings (or Capitalized Earnings)
method. Capitalization refers to the return on investment that is expected
by an investor. There are many variations in how this method is applied.
However, the basic logic is the same.
To demonstrate the capitalization method of valuation, let's look at a
mythical and highly oversimplified business. Pretend the business is simply
a post office box to which people send money. The magic post office box has
been collecting money at the rate of about $10,100 per year steadily for ten
years with very little variation. It is likely to continue to collect money
at this rate indefinitely. The only expense for this business is $100 per
year rent charged by the post office. So the business earns $10,000 per year
($10,100-$100). Because the PO box will continue to collect money
indefinitely at the same rate, it retains its full value. The buyer should
be able to sell it at any time and get his initial investment back.
A buyer would look at this "minimum risk" business earning $10,000 and
compare it to other ways of investing his or her money to earn $10,000 per
year. Let's assume a near no risk investment like a savings account or
government treasury bills currently pays about 8% a year. At the 8% rate,
for someone to earn the same $10,000 per year that the magic PO box earns,
an investment of $125,000 (125,000*8%= $10,000) would be required.
Therefore, the PO box value is in the area of $125,000. It is an equivalent
investment in terms of risk and return to the savings account or T-bill.
Now the real world of business has no magic PO boxes and no "no risk"
situations. Business owners take risks and have expenses, and business
equipment can and usually does depreciate in value. The higher the perceived
risk, the higher the capitalization rate (percentage) that the buyer will
use to estimate value. Rates of 20% to 25% are common for small business
capitalization calculations. That is, buyers will look for a return on their
investment of 20% to 25% in buying a small business. However, as we'll see
below, some businesses have value to some buyers for reasons that have
little to do with the amount of money they are earning.
Finally, it is important to point out that the above example does not
include a fair salary for the new business owner. If the owner must devote
time working to realize a profit, he or she must, in theory, be paid a fair
value for that work. The owner's fair and reasonable salary must be
separated from the return on investment computations. For example, if the
magic PO box produced $30,000 per year but required a manager with a fair
market salary of $20,000, the income for valuation purposes is $10,000, not
$30,000. The fair market value for salary is the important number to use,
not the actual salary to the current owner. |
| This method is similar to the capitalization
method described above. The difference is that it splits off return on
assets from other earning (the excess earnings). For example, let's
suppose Mr. Owner runs a business that manufactures novelty products. His
company has Tangible Assets of $300,000. Further let's suppose that Mr.
Owner pays himself a very reasonable market value salary-- the same amount
that he would have to pay a competent manager to do his job. After paying
the salary Mr. Owner's business has earnings of $120,000.
The financially rational reason for owning business assets is to produce
a financial return. Let's say that a reasonable return on Mr. Owner's
Tangible Assets is 15% per year. A reasonable number here should be based on
industry averages for return on assets adjusted to current economic
conditions. For example, Mr. Owner or his advisors may have looked up
industry standards for novelty manufacturing shops and found that the
current average return on assets was 14%. (An alternative approach to
finding an industry appropriate return on asset figure is to use a rate 2 to
3 points above the current bank rate for a small business loan, or about 5
points above the current prime rate).
So $45,000 of Mr. Owner's profits are derived from the tangible assets of
the business ($300,000 x 15%= $45,000) The other $75,000
($120,000-$45,000=$75,000) in earnings are the excess earnings).
This $75,000 excess earning number is typically multiplied by a factor of
2 to 5 based on such factors as the level of risk involved in the business,
the attractiveness of the business and the industry, competitiveness, and
growth potential. The higher the factor used, the higher the estimate of the
business will be. A typical number is 3 for a solid, profitable company.
That is, a good business that is judged to be average in terms of the level
of risk involved, the attractiveness of the business, the industry,
competitiveness, and growth potential would use three as a multiplier. The
actual factor used is a mix of opinion, comparison to others in the
industry, and industry outlook.
Let's suppose that Mr. Owner's business is a bit better than average in
these factors and assign a multiplier of 3.6. Therefore, the value of this
business can be determined as follows:
| A. Fair market value of tangible equipment |
$300,000 |
| B. Total Earnings |
$120,000 |
C. Earnings attributed to Tangible Assets
($300,000 x 15%=$45,000) |
-$45,000 |
|
D. Excess Earnings
($120,000 - $45,000=$75,000) |
$75,000 |
E. Value of excess earnings
($75,000 x 3.6=$270,000) |
$270,000 |
|
| F. Estimated Total Value (A+E) |
$570,000 |
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The capitalization methods work for businesses that derive their income
primarily from tangible assets such as a utility (such as gas or electric
companies). In the case of most small businesses that earn only a small part
of their revenues from tangible assets, the excess earning method is
probably a better method to use. |
| Buyers often look at a business and evaluate
it by determining how much of a loan the cash flow will support. That is,
they will look at the profits and add back to profits any expense for
depreciation and amortization but also subtract from cash flow an estimated
annual amount for equipment replacement. They will also adjust owner's
salary to a fair salary or at least an acceptable salary for the new owner.
The adjusted cash flow number is used as a benchmark to measure the
firm's ability to service debt. If the adjusted cash flow is, for example,
$100,000, and prevailing interest rates are 10%, and the buyer wants to
amortize the loan over 5 years, the maximum a buyer is willing to pay for
the firm would be $392,211. This is the amount that $100,000 per year would
support over 5 years.
Therefore, when using this method, the value of a
company changes with interest rate conditions. It also changes with the
terms a buyer can obtain on a business loan. From a buyer's perspective this
may make sense, but from a seller's perspective it introduces a sort of
arbitrariness into the process. |
| In some instances, a business is worth no
more than the value of its tangible assets. This would be the case for some
(not all) businesses that are losing money or paying the owner(s) less in
total than a fair market compensation. Selling such a business is often
a matter of getting the best possible price for the equipment, inventory,
and other assets of the business. It is generally best to approach other
firms in the same business that would have direct use for such assets. Also,
a company in the same business might be interested in taking over your
facility. This would mean your leasehold improvements (modifications to
space, etc.) would have value and the equipment would have value as "in
place" plant and equipment. In place value is higher than the value on a
piece by piece basis such as at a sale by auction. |
| Sometimes companies or individuals will
purchase a company just to avoid the difficulties of starting from scratch.
The buyer will calculate his or her start up needs in terms of dollars and
time. Next he or she will look at your business and analyze what it has and
what it may be missing relative to the buyer's start up plan. The buyer will
calculate value based on his or her projected costs to organize personnel,
obtain leases, obtain fixed assets, and cost to develop intangibles such as
licenses, copyrights, contracts, etc.).
A reasonable premium of above the sum of projected start up costs may be
offered because of the effort and time being saved by the buyer.
The more difficult, expensive, and/or time consuming
startup is likely to be, the higher the value would be based upon this
method. |
| One of the most common approaches to small
business valuation is the use of industry rules of thumb. While most
financial analysts cringe at the use of these approaches, they do have their
place, which we believe to be as adjuncts to other methods.
One industry rule of thumb says an Internet Service Provider company is
worth $75 to $125 per subscriber plus equipment at fair market value.
Another says that small weekly newspapers are worth 100% of one year's gross
income.
The problem with these and all rule of thumb formulas is that they are
statistically derived from the sale of many businesses of each type. That
is, an organization might compile statistics on perhaps 100 small weekly
newspapers that were sold over a two year period. They will then average all
the selling prices and calculate that the average paper sold for 100% of one
year's gross income. The rule of thumb is thus created. However, some
newspapers may have sold for twice one year's gross while other may have
sold for half of one year's gross.
The rule of thumb averages may be accurate for those businesses whose
performances are right about at the average. The business with expenses and
profits that are right on target with industry averages may well sell for a
price in line with the rule of thumb formula. Others will vary. To apply the
rule of thumb to a business that varies significantly from the average is
not appropriate. |
| This is an often overlooked approach to
valuation. Yet in some cases it is the only appropriate approach that will
result in a sale. The approach is based upon the buyer's buying a wanted
intangible asset versus creating it. Many times buying can be a cost
efficient and time saving alternative.
For example, we recently sold a temporary employment agency. This agency
specialized in placing health care assistants (such as nurses aids) in
hospitals and nursing homes. Because there is a shortage of these workers in
the area where the selling company did business, placing workers was not
difficult. However, finding qualified workers was very difficult.
We approached firms in the same and related businesses. Through our
research, we calculated that recruiting a qualified worker cost at least
$200 for an agency. Therefore, we were able to obtain a price of $170.00 for
each worker in the pool of available employees by showing a competitor that
this would save them money.
In fact, this not only saved $30.00 per worker, but it also cut down on
recruiting time to recruit. The overhead of the selling company was not an
issue because the buying company already had the system in place that the
overhead expense was paying for (offices, computer system, phones, etc.). In
fact, whether the seller was making or losing money was of little
consequence to the buyer. The value to the buyer was the value of buying a
qualified worker versus recruiting a worker through the more traditional
method of advertising, interviewing, etc.
A common application of this method is the acquisition of a customer
base. Customers with a high likelihood of being retained are valuable in
most industries. Examples of industries where companies are bought and sold
based upon the value of the customer base include insurance agencies,
advertising agencies, payroll services, and bookkeeping services.
In practice the buyer will often ask for a credit for each customer that
is not retained for a stated period of time. For example, a firm may offer
$100 per customer, with a pro-rated credit for each customer lost during the
twelve months following the closing of the sale. Pro-rating is based upon
the time the customer is lost-- if the customer is lost after 6 months, for
example, half of the $100 would be returned to the seller. |
| There is no surefire way to value a company
for buying and selling purposes. The true value is the perceived value to a
buyer who is ready, willing, and able to buy it. However, there are a number
of approaches to estimate value; some of those are discussed above. It is
not unusual for a buyer to ask for the logic behind an asking price. Having
a good answer to that question will enhance your chances of selling your
firm for the desired price. If you would like our help
in valuing your company, please e mail
alanAlan@FrontlineFloridaRealty.com.com |
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