Business Valuation 101 – Understanding the Basics
By Kimberly Robison, CPA | Senior Associate, Business Valuation
Understanding and determining the value of a business is a service provided by trained and certified business appraisers. In domestic relations court, the court often turns to experienced and credentialed professionals to value marital assets, such as a privately held business. The first step to the business valuation process is engaging the appropriate professional.
When a business appraiser is engaged, there are several steps necessary for an appraiser to perform an analysis. The appraiser initially creates a valuation information request, generally sent through the legal channels of the discovery process. The information request typically contains items to elucidate form of organization and ownership, financial condition, products and services, markets and customers, operations, facilities and equipment, personnel, and includes requests for corporate documents and records, among other things. The appraiser also studies available economic and industry-specific resources to analyze a company in the context of its broader economic and industrial environments. When possible, a management interview can play an important role in the valuation process.
Another essential step in the valuation process involves normalization adjustments to the balance sheet and income statement, based on the research described and discussions with management. Normalization adjustments should reveal what prior operations might have looked like under normal conditions and what benefit a prospective buyer might reasonably expect to obtain from a company based on normal operations. The financial statements must reliably reflect the true operating performance of the entity through the removal of what the appraiser deems to be distortions.
For valuation purposes, the company’s balance sheet should present all assets and liabilities related to its operations as close to fair market value as possible. Typical adjustments include:
- Adding operating assets or liabilities excluded from the balance sheet
- Adjusting presented assets or liabilities to fair market value
For example, if an accounts receivable amount is missing from a balance sheet prepared on a cash basis, accounts receivable may be added based on an estimate or accounts receivable aging schedule. If an accounts receivable amount is already disclosed on a balance sheet, that amount may need to be adjusted to fair market value by deducting uncollectible amounts.
Income statement adjustments to normalize earnings include the following:
- Removing the impact of nonrecurring or nonoperating income/expenses
- Adding the impact of operating income/expenses expected to be newly recurring moving forward
- Adjusting income/expenses that are too low or high compared to fair market rates
Common income statement adjustments involve normalizing owner or family member compensation levels that are less than or higher than reasonable market rates based on industry benchmarks. Fringe benefits the company provides to the owner or family members that are inessential to operations are often an add-back to earnings as well. Related party revenues or expenses are adjusted to fair market rates. Nonrecurring expenses, such as a significant expense associated with unusual litigation, are often normalized. After the necessary earnings adjustments have been made, income taxes are recalculated based on normalized pretax income.
After normalization adjustments have been made to the balance sheet and income statement, business valuation approaches can then be applied to determine value. Several different business valuation approaches may be considered by a business appraiser. The three most widely practiced approaches include the following:
Cost/asset approach: The cost/asset approach focuses on the net asset value of the company, which is calculated by subtracting the fair market value of total liabilities from the fair market value of total assets. After adjustments, the net asset value represents what operating assets the company would retain after satisfying its outstanding obligations. This approach generally results in a “floor” value for the company as it generally disregards significant items of intangible value, such as a customer following or positive reputation.
Income approach: The income approach values company ownership based on the present value of economic income expected to be generated. The valuation professional estimates future cash flow and then determines the present value using a rate of return called the discount rate. The discount rate represents the rate of return potential buyers would expect from their investment in the company. The higher the investment’s risk, the greater the rate of return expected, resulting in a lower present value of future cash flow. Inversely, the lower the investment’s risk, the lower the rate of return expected, resulting in a higher present value of future cash flow. A company can represent a lower or higher investment risk based on industry, size of the company, depth of the management team, customer concentration, regulatory environment, etc.
The most common methods practiced under the income approach include the capitalization of earnings method and the discounted cash flow method. The capitalization of earnings method is most suitable when an entity’s future earnings are expected to increase at a stable rate. A single period or average of historical periods is used to represent a sustainable earnings base for the company, and a capitalization rate utilizing an appropriate discount rate adjusted for expected growth is used to convert the sustainable earnings base into a suggested present value. The discounted cash flow method is most suitable when a company’s future performance is expected to vary. This method generally utilizes cash flow projections supplied by management over a several year period (usually five years). A normalized level of cash flow is reached in the last year of the projection period. The future cash flow projection is then discounted back to present value using the appropriate discount rate.
Market approach: The market approach is a valuation approach that involves valuing a company based on actual transactions that have already occurred in both public and private markets.
The most common methods practiced under the market approach include the guideline public company method, and the guideline merged and acquired company method. For the guideline public company method, the valuation professional will look for companies with securities trading on public markets in the same or a similar line of business. Companies are also considered who have roughly the same financial profiles and are facing similar risks as the company to be valued. Price multiples derived from the sample of comparable public companies are multiplied by the adjusted performance measures of the subject company to calculate suggested values. The guideline merged and acquired method requires access to databases with the prices at which interests in mostly privately held companies comparable to the subject company have been acquired in arm’s-length transactions. This method is generally more suitable than the guideline public company method when the company to be valued is smaller with niche products or service offerings. Valuation multiples from transactions of comparative merged and acquired companies can be applied to estimate the fair market value of the subject company after considering the terms, prices, and conditions of the transactions. Examples of commonly used “multiples” for both market approach methods include the price paid for a company divided by sales or divided by some measure of earnings, such as earnings before interest, tax, depreciation, and amortization (EBITDA).
Understanding the value of a business is a process that should be handled by qualified professionals. Determining a business’ value can be completed for preparation of a sale, merger and acquisition, or to begin an owner’s succession plan. To start the process of valuating a business, contact Apple Growth Partners’ dedicated team today.