|What is the Market Value of your business ?
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It is essential to place the right value on your business
for any of the following purposes:
* Sell your business at the Fair Market Value
*Provide a lender with Fair Market Value information
for a business loan
*Plan for a merger, acquisition or stock offering
*Develop an estate plan or tax plan to protect your wealth
* Update a buy-sell agreement
*Transfer of the business into a trust or
create a succession plan
*Determine the value of assets and
liabilities for a divorce settlement
*Assist attorneys in litigation
*Settlement of an insurance claim
*Set up an Employee Stock Ownership Plan (ESOP)
Whatever its purpose, a valuation can play a key role
in helping you achieve your financial goals.
Methods of Business Valuation:
by Gary L. Schine
1. Capitalized Earning Approach
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. The logic is readily
understandable to any business person -- it's as simple as evaluating return on investment based on the risk
involved. As simple as it is, it provides a good understanding of how a buyer may initially approach valuating
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 4% a year. At the 4% rate, for someone to earn the same
$10,000 per year that the magic PO box earns, an investment of $250,000 (250,000 times 4%= $10,000)
would be required. Therefore, the PO box value is in the area of $250,000. 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 25% to 35% are common for small business capitalization calculations. That is, buyers will look for a return
on their investment of 25% to 35% 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.
2. Excess Earning Method
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 $900,000. 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
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.
So $135,000 of Mr. Owner's profits are derived from the tangible assets of the business ($900,000 x 15%=
$135,000) The remaining $225,000 ($360,000 - $135,000 = $225,000) in earnings are the excess earnings.
This $225,000 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
multiplier number is 3 for a solid, but not spectacular small 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. 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 $900,000
B. Total Earnings $360,000
C. Earnings attributed to Tangible Assets
($900,000 x 15%=$135,000) -$135,000
D. Excess Earnings
($360,000 - $135,000=$225,000) $225,000
E. Value of excess earnings
($225,000 x 3.6=$810,000) $810,000
F. Estimated Total Value (A+E) $1,710,000
The capitalization methods work best for medium size businesses that have substantial assets such as
receivables, inventory, and/or fixed assets.
3. Cash Flow Method
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, $300,000, and prevailing interest rates for business loans are 8%, and the
buyer wants to amortize the loan over 5 years, the maximum this buyer would be willing to pay for the firm
would be about $1.2mm. This is the amount that $300,000 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.
4. Tangible Assets (Balance Sheet) Method
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.
5. Cost To Create Approach (Leap Frog Start-Up)
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.
6. Rule of Thumb Methods
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 a payroll service customer is worth 1.5 to 2 times its annual service fees.
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.
7. EBITDA Method
Some buyers value a company by simply multiplying the Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA) by a factor, typically in the 3 to 6 range. This straightforward approach tends to be
used for companies with sales over $5,000,000 that has a management infrastructure in place
The advantages are:
1. It avoids the issue of depreciation and amortization, since most companies use a depreciation and
amortization schedule that is intended to take best advantage of the prevailing tax laws. It avoids the issue of
taxes, which usually vary according to the ownership structure
2. It is uncomplicated, and most useful for companies that are well established and earnings are consistent
and predictable going forward
3. It lends itself to comparisons with similar sales
4. It is most suitable for companies larger then 5MM in revenue, especially companies where variations in
tangible assets do not significantly effect the value of the company
The disadvantages are:
1. It makes no distinction between companies that have a large working capital requirements (current assets,
less current liabilities), versus small working capital requirements
2. It makes no distinction between companies that have large fixed asset needs, vs. Small fixed assets
3. It makes no provision for companies that have very substantial real depreciation (e.g. Trucking companies,
where the trucks rapidly decrease in value) as opposed to companies where actual decrease in asset value is
less than the IRS depreciation allowance. In some cases EBIT is used instead of EBITDA when there are
large, recurring depreciation expenses.
Even when the EBITDA method is appropriate for valuation, certain adjustments and allowances need to be
made before the simple formula can be applied. And of course, the actual multiplier used (whether 3 or 4 or 5
or some other number) is likely to be vigorously negotiated between buyer and seller.
If you would like to know if the EBITDA method may be appropriate for your company, please contact us.
8. Valuation based on Synergies
In some instances, a buyer will pay a somewhat higher price than any of the above methods would justify.
This could be the case when a buyer sees clear and immediate synergies; if the buyer can make 2 + 2= 5. A
strategic buyer may pay a premium if for example, he can gain immediate and sizable economies of scale,
gain a new distribution channel for his existing products, or a new product that can take immediate advantage
of his existing distribution channels. A buyer may consider this method of valuation when a very high
proportion of the seller's gross revenue will, after the acquisition, fall to the buyer's bottom line.
A few examples based on synergies include:
Large Payroll service companies (such as Paychecks or ADP) often acquire smaller companies in their
industry. When they do so, they are more concerned with top line income than bottom line profit. More
accurately, they are concerned with what the bottom line income would be if they were to transfer the selling
company's customer base to their own system where they have excess capacity. They can add incremental
payrolls without a corresponding increase in expenses. A payroll service company that has gross receipt of
say, $500,000 and is breaking even, could represent a profit of several hundred thousand dollars to an
acquire already in the business that can process more efficiently and can eliminate much of the smaller firms
To the buying payroll service company, a more important calculation than the selling company's earnings is a
comparison between the cost of gaining customers through acquisition vs. The cost of gaining equivalent
customers by traditional methods like hiring salesmen, advertising, etc. Because payroll service firms can
accurately estimate their processing expenses based on gross revenues, these companies tend to sell for a
multiple of their annual gross sales with only minor regard for their profit or loss.
An outdoor furniture company looking to acquire a complimentary company. They had great distribution of
their porch and patio furniture and specifically wanted to acquire a company that made or imported a product
that could be sold through the channels they had built. An importer of wicker planters that matched its
distribution channel perfectly. They agreed to pay a premium based on the synergies they knew they could
A mail order seller of knitting supplies for sale. A large mail order company of quilting supplies, by showing
them how they would gain economies of scale, synergies, and customers that could be cross-sold (knitting
customers would buy quilting supplies and vice-versa). The buyer paid a premium justified by the excellent
There are companies that overplay this synergy concept by claiming to be in touch with buyers who will pay
far more for your business than any valuation method would justify. They may be foreign buyers who are
anxious to get a foothold in the US or other synergistic buyers who will pay for hidden assets. Their
arguments are quite seductive; who doesn't want to sell their business for twice its value?
However, the rest of the sales pitch is that you need to pay them a large amount of money upfront, as much
as $50,000, or the names of these overly generous buyers won't be revealed. They make their money
primarily based on the upfront fees. After you pay the upfront fee, you'll get a very nice write-up of your
company with fancy charts and printed on the finest cloth weave paper, but you won’t get a buyer to overpay
for your company.
When buyers buy based on synergies, they typically pay a reasonable premium over the financial methods
described previously, or based on some logical method that reflects the buying companies likely earnings
(such as with payroll service companies, above). For example, instead of using a multiple of 3.5 times
EBITDA, they’ll use 4.5 times EBITDA. Now the difference between a multiple of 3.5 vs. 4.5 is significant to be
sure, but it is not the double or triple valuation that you were promised, before you paid the hefty upfront fee.
We (and other honest intermediaries) make our money based on performance, not on upfront retainers. We
have no incentive to make unsubstantial claims of buyers willing to throw logic to the wind and pay huge sums
for your business. We only get paid for making the deal, not for talking about it.
Get things started by calling 626-673-5344
What affects the market value of a business enterprise?
- Business Enterprises market share & profitability
- Regulatory changes
- Return on Investment outlook
- Competition landscape
- Technology for new entry
- Economic / Industry / Market demand (trend)
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|Four Pillars of Enterprises Valuation