Disclaimer: This article simplifies the method used by business valuators to determine what value a business might command in the market. It is not in any way a substitute for a professional valuation, and the author is not a professional business valuator. It is for reader interest only, to inform you about some of the factors and methods used in business valuation.

businessThe value of any business, just like the value of your house, is the highest amount that an informed buyer would be willing to pay for it. The marketplace is the final arbiter of value. Nevertheless, there are some rules of thumb that can be used to make an educated guess what a buyer might be prepared to pay.

The traditional rule of thumb is that a business is worth the Present Value of its expected future net cash flows (i.e. cash taken in less cash paid out). The discount rate used to compute the Present Value should reflect the risk (uncertainty) of realization of those cash flows — the higher the uncertainty, the higher the discount rate and hence the lower the business value. This assumes that the business is a ‘going concern’, i.e. that it makes sense to continue to operate it to realize those future cash flows. If this computed value is less than the liquidation value of the business (the realizable value of the assets less liabilities if everything was sold as-is today) then the business is worth its liquidation value instead (and consideration should be given to winding it up).

Here’s a step-by-step method for computing an approximate ‘going concern’ value:

  1. Separate the assets and liabilities of the business into operating assets and liabilities, real estate assets and liabilities, and investment assets and liabilities (those not essential to the operations of the business).
  2. Calculate the normalized annual cash flow of the business. To do this, start with the average annual pre-tax operating income (exclude income and expenses related to investment assets and liabilities) over several recent and projected fiscal years. Add back to this any expenses that don’t involve cash: depreciation and amortization, discretionary management bonuses (beyond what a professional business manager would be paid to run the business), and non-recurring expenses. Subtract any non-recurring income and the average annual capital expenditures needed to keep the capital assets of the business in good operating condition. The result is the Normal Pre-tax Cash Flow.
  3. Next calculate the amount of unutilized financing available to the company. A common rule of thumb is that lenders will lend up to 50% of the realizable value of equipment, 60% of the realizable value of working capital (receivables plus inventory less trade payables), and 75% of the realizable value of real estate assets. From the sum of these three calculations, subtract current debt on these assets (bank loans, mortgages, lines of credit etc.) The result is the Unutilized Financing. Now multiply the Unutilized Financing by the company’s current borrowing rate (ask the bank for current rates on these types of loans) to compute the Interest on Unutilized Financing.
  4. Now determine an appropriate Capitalization Rate (the inverse of the discount rate used to calculate the Present Value). For private companies this rate will usually be between 1 and 8 while for public companies (with greater liquidity and access to capital) this rate will usually be between 1 and 12. Some factors to consider in determining what rate in this wide range to use include: stability of past earnings, intensity of competition, barriers to new companies entering this market, business reputation, reliance of the business on existing management, key personnel and key customers, stability of supplies used in operations, financial strength of customers, business growth potential, business liquidity, profit margins and turnover (how quickly inventory is sold and replenished). Adjust the capitalization rate for tax by multiplying by (1 minus the current effective tax rate). It’s usually advisable to determine a minimum and maximum Tax-Adjusted Capitalization Rate, since this is so subjective.
  5. Next, take the Normal Pre-tax Cash Flow from step 2, subtract the Interest on Unutilized Financing from step 3, and multiply the result by the Tax-Adjusted Capitalization Rates from step 4. Then add the Unutilized Financing from step 3, and add the fair market value of the net real estate and net investment assets from step 1.

Let’s look at an example. Suppose your business has $100,000 of net operating assets (cash, receivables, inventory, equipment, less trade payables and operating loans), and $150,000 of (net of mortgages) real estate assets, and $50,000 of (net of investment loans) investment assets (at current realizable value after any taxes). Suppose that, averaging the last three years’ actual income and the next two years’ forecast income, and adding back each year’s depreciation expense, you compute Normal Pre-Tax Cash Flow to be $200,000. And suppose you could theoretically borrow an additional $100,000 on your real estate assets at 10% interest. And let’s say your business is computer animation, which is fast-growing but very competitive, so you determine an appropriate pre-tax Capitalization Rate range to be 4 to 6 times (i.e. discount rate of 17-25%), and Tax-Adjusted Capitalization Rate range to be 3 to 4.5 times. In other words, the business risk is such that if it were you investing in it, you’d want to earn a 17-25% pre-tax return on that investment (average per year over time) — a high rate, but in the zone any ‘venture capitalist’ would expect.

Applying the calculations above, $200,000 Normal Pre-Tax Cash Flow minus $10,000 Interest on Unutilized Financing, times 3 (minimum) or 4.5 (maximum), plus $100,000 Unutilized Financing, plus $150,000 Real Estate value, plus $50,000 Investment value, equals $870,000 (minimum) to $1,155,000 (maximum) total theoretical value of the business.

Professional business appraisers have developed sophisticated methods of determining appropriate capitalization rates based on analysis of recent comparable business sales. Also, some assets have additional value (or in some cases diminished value) depending on the tax treatment they will receive in the hands of the buyer, or when ownership is transferred. In addition, the tax and accounting treatment is different depending on whether it is the business entity’s shares, or the assets and liabilities, that are sold, and this also affects the business’ value.

If you’re interested in learning more about business valuation, here’s a Powerpoint presentation that shows many of the techniques that business appraisers use, and much more detailed valuation formulae. But remember, these calculations are the theoretical value only. The computations are only as good as the quality and validity of the underlying assumptions and forecasts. And the market often behaves in unexpected ways, ascribing value because, for example, the purchase offers synergies or sentimental appeal to the buyer. In addition, buyers sometimes ascribe too high or too low a capitalization rate because of inaccurate perceptions of the risk or growth potential of the business.

And sometimes the real value of the business is in its key management members and employees, who, if they’re not motivated to stay with the new owners, can severely reduce or even eliminate the business’ value to a purchaser. That’s why few owner-managed businesses command the market price their owners expect. A surprising proportion of all mergers and acquisitions fail to add as much value to the buyer as expected.

I’d like to see a Monopoly-type game that used these theoretical valuation calculations to set and constantly adjust prices for each property on the board, and allowed players to buy and sell any property, with some serendipitous variation in the calculations built in to make the game interesting and life-like. It would be a great educational tool that, if it also included a simulation of business operations, could help provide our young people with some valuable entrepreneurial skills and insights. Anyone for Sim-Biz?

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