Seven ways to determine what your business is worth
On the Money
From the February 4, 2005 print edition
There are a number of reasons for valuing a business-sale or purchase of the entity, estate and tax purposes, and for raising capital. If a company is public, these valuation methods have nothing to do with the stock price.
The worth of a business is based upon two major factors: the assets owned by the concern (tangible or intangible) and the income stream being generated by the firm’s operations. In other words, static property owned or continuing money flow from operations.
Within those two broad categories, the seven methods below will facilitate constructing a reasonable value.
- Particularly in the high-technology industry, the value of a company may be based primarily on one specific static asset value; often the intangible asset is intellectual property.
This approach is usually based upon the buyer’s desire for a particular intangible asset; frequently a new proprietary technology protected by patent or trade-secret. The price offered will reflect the buyer’s assessment (often not revealed to the seller), of the expected profit from the asset. The best example is Bill Gate’s purchased of the first PC operating system which launched Microsoft.
- In some instances, a business is worth no more than the fair value of its tangible assets, or “liquidated value.” Valuing a business in this way is simply a matter of obtaining the best possible price for the equipment, inventory, and other assets of the business. An interested party in a similar industry may want the assets left in place. In place value is generally higher than on a piece by piece basis at auction.
- The leapfrog startup approach is used when the purchaser wants to avoid the difficulties of starting from scratch. The buyer calculates the start up requirements in terms of dollars and time, including projected costs to organize personnel, obtain leases, obtain fixed assets, and the cost to develop intangibles such as licenses, copyrights, and contracts.
A reasonable premium may be offered because of the effort and time being saved by the buyer. The more difficult, expensive, and time consuming getting underway is likely to be, the higher the value based upon this method.
- One of the most common flow-method approaches to valuation is the use of a market value multiplier. When analyzing gross sales, gross sales plus inventory, or after tax profits of comparable businesses in the industry, a multiplier is applied to create a value. Obviously, the construction of the multiplier is critical. This method is similar to price-earnings ratios used is stock price evaluation.
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 revenue.
- For mature companies, capitalization of earnings is appropriate. The Capitalization Rate is the expected return on investment to the investor or purchaser.
This technique of valuation is suitable for established service companies and other non-asset intensive businesses that have few if any, fixed assets.
The basic formula determining capitalized earnings is: projected earnings divided by capitalization rate equals value. The capitalization rate is a probable risk level.
A reasonable capitalization rate considers factors such as the length of time the company has been in business, longevity of current ownership, reasons for selling, operating and legal risk factors, profitability, location, barriers to entry and exit, level of competition, industry potential, technology, and others.
- The excess earnings method is similar to the capitalization method described above except that returns from fixed assets are separated from other earnings– hence “excess” earnings.
The two capitalization methods work for businesses that receive their income primarily from tangible assets such as a utility or stable manufacturing concern. In the case of businesses that earn only a small part of their revenues from tangible assets, the excess earning method is probably a better method to use.
- Using the cash flow method is most appropriate when one firm desires to acquire another firm in the same industry and borrowed funds will be used to consummate the transaction. Therefore the evaluation will center on how much of a loan the cash flow will support. Typically profits are adjusted for depreciation and amortization and an estimated annual amount for equipment replacement.
If cash flow is, for example, $1 million and prevailing interest rates are 10 percent, and the loan is amortized over 5 years, the value would be $3,922,110. On a fully amortized basis over 5 years, total interest is about $1,000,000.
Determining the value of a business is more of an art than a science and it is not precise. Ultimately the value is the result of face-to-face negotiation between the seller and buyer.
© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.