It seems like a simple question but the answer is usually complicated and starts out, “Well that depends…”
Is the valuation for a buyer, seller, estate plan, banker or a divorce settlement?
Here are some basics:
You will need to determine the fair value of the assets and liabilities. In doing so consider the following:
1) The value of the assets for accounting purposes is different than fair market value. A good example is real estate that is shown at cost even if it was purchased in 1964. Take out the cost and put in the fair market value.
2) There will be some income tax owing if you sold the assets at a profit. The estimated tax is often deducted in calculating the value.
3) There could be intangible assets that don’t show up on the balance sheet. This could be great employees, a profitable long-term contract with a customer or a website domain name. These would be added to the value. Also consider contingent liabilities such as a long-term lease commitment at higher than market rent.
You also need to get an idea about how much future cash flow/income the business can generate. You typically use the historical results to project the future but adjust for any known or expected changes. Consider the following in determining the future profits:
1) The current owners are probably not being paid based on what they are worth. Whether the owners are underpaid or overpaid, it is necessary to take out the actual pay and put in a fair amount to pay someone to replace the owners in the business. This is called the ‘economic’ salary and is deducted before determining the bottom line income.
2) Adjust for any abnormal factors. If the owners are taking a lot of perks – adjust for that. If the rent or other expenses are not at fair market value – adjust it to be reasonable. This is called ‘normalizing’ the income. It should be what a purchaser would expect to earn under ‘normal’ circumstances.
3) Determine an average income for the most recent years or average cash flow for the projected future.
The next step is to determine an earnings multiple. This is calculated based on the risk in the business. The more risk, the higher the multiple. For example, it is common to apply a 4 times earnings multiple to a small business. If the average earnings is $50,000 then the value based on earnings is $50,000 x 4 = $200,000. This is equivalent to expecting a 25% return on investment. As you can see, the choice of earnings multiple has a big effect on the value.
Once you have a value based on the fair market value of the assets and the liabilities, you compare that to the value based on a multiple of expected cash-flow income. If the asset value is higher, you typically take the asset value as the final value. A good example would be a farm business that may not always have high income, but the business is always worth at least the market value of the farmland.
If the value based on earnings is higher, you can try and find a happy midpoint. It is harder to argue the earnings value because it is based on the most subjective calculations.
The above summary will give you just enough information to be dangerous! There is an entire profession of business valuators who would be offended at my attempt to simplify the valuation process.
In summary, it is worthwhile to have some understanding of the valuation process to determine your business’s value.
If you would like to explore the value of your business further please feel free to contact me at firstname.lastname@example.org.