An introduction to how businesses are appraised.

Valuation Basics

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Is business valuation more of an art or a science?
For many business owners, it feels more like voodoo – mysterious and inscrutable. The factors that drive business appraisal, however, are the common forces that drive financial markets and understanding the basics of valuation is a simple extension of the everyday knowledge it takes to run a business. This article is designed to acquaint you with these basics and learn how Ezvaluator determines the value of your business.

Fair Market Value: The Gold Standard for Business Appraisal

Simply stated, a business is worth what a buyer will pay for it. This is a cornerstone of free market economics. For publicly held companies traded on open exchanges, value is set by the subtle and complex interplay between thousands of buyers and sellers acting on similar information. This establishes a market price based on consensus and driven by the law of supply and demand. Anyone who has ever traded stock has seen this dynamic in action.

Privately held business play by a different set of rules. There is no market with millions of traders to establish value by consensus. There are no publicly available financials calculated according to a single accounting standard. As a result, there are many existing definitions and standards of value, each defining “value” from a different perspective. Fair Market Value (FMV) is the most common standard of value used in business appraisal. It is defined by the American Society of Appraisers as “the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have a reasonable knowledge of the relevant facts.” There are two key components to this definition:

A willing seller and buyer not acting under compulsion. In other words, there is not an overriding need (other than desire) driving the transaction. The seller is not selling the business because of dire need (at a “fire sale” price) and the buyer is not paying a premium because of some urgent reason to buy.
A reasonable knowledge of the relevant facts. Both parties are able to arrive at a fair, rational decision because each is aware of the issues involved and neither is withholding critical information.

Business appraisals that establish FMV (like Ezvaluator’s) assume a transaction that abides by these two guidelines. The result is a market price that is perfectly suited for the sale of a business under normal circumstances and one that is based on an accepted basis of value.

Owner’s Cash Flow: The Critical Factor

No other component used in the calculation of FMV is more important than the owner’s cash flow (OCF). OCF is defined as the total financial benefit an owner receives from his or her business. This sounds a lot like profit, right? Kind of, while profit plays a part in determining OCF, it’s not the only factor.

Most owners of small closely held companies work hard to minimize the profit they report in order to decrease their tax liability. On top of this, many owners tend to mix personal expenses with business expenses (things like using a company car for non-business purposes or taking company goods or services at cost).There is rarely any dishonest intent behind these actions, they simply reflect the way most small business owners do business.

The end result, however, is a bottom line profit that is usually significantly lower than the actual value of the benefits an owner gains from a business. In the world of business appraisal, greater OCF translates directly into higher fair market value. Consequently, one of the main activities involved in business valuation is the adjusting or “recasting” of earnings to accurately reflect the owner’s economic benefit.

To calculate owner’s cash flow, a valuator takes net profit and adds back a number of expenses. The most common of these include:

Salaries Business owners frequently pay themselves and relatives that they employ larger salaries. The additional amount of salary that an owner (and family members) take from a business above and beyond the replacement value of their labor is added back to cash flow.
Depreciation and Amortization This is a so-called “phantom expense” – one that reflects an abstract accounting concept rather than an actual outlay of cash. These are not actual expenses and should also be considered as an add back.
Interest Expenses Because most businesses are sold on a debt-free basis, the amount of interest paid is an add back. The reason for this is that a new owner’s financing arrangements (if any) on the business may be significantly different than the current owner’s financing.
Discretionary Expenses (Perks) Any non-business related expenses that an owner runs through a business are added back when calculating OCF. For many business owners, this can be a significant amount.

Determining Value: Three Approaches

After determining a company’s OCF, a valuator can begin to establish its actual value. Professionals typically use a blend of several different methods to calculate value. This helps ensure that a broad range of perspectives are encapsulated in the final amount. There are three basic types of valuation approaches

The Asset Method determines value based on the value of things a company owns (inventory, accounts receivable, real estate, equipment, etc.). From the average owner’s perspective, this is the most intuitive of the three methods. It is relatively easy to understand how a company’s market value is directly related to the value of the “stuff” it is made up of. What this method fails to identify, however, are a business’s intangibles – things like reputation, customer relationships and intellectual property. This is where the other two methods are useful.

The Income Method determines the present value of all future cash flow earned by the owner. This one is a little less straightforward. The thing to keep in mind is that buyers of a business are actually buying the promise of future earnings (what we defined previously as OCF). However, as everyone experiences in their day to day financial dealings, a dollar today is worth more than the promise of a dollar in the future. This is why we pay interest on money that is loaned to us.

In business valuation, this phenomenon is accounted for by the discounting of future cash flows to the value that they’re worth today. It is the sum of all of these future discounted cash flows that determines a company’s value according to the income method. Though a little difficult at first to grasp, this method is considered to be the most accurate reflection of a company’s FMV.

The Market Data (Comparable Transaction) Method uses actual business sales to determine a company’s value. By identifying a set of similar businesses (by factors like industry, size, profitability, location) that have actually sold, certain pricing multiples – relationships between sale price and factors like OCF and revenue – can be identified. Like the Asset Method, this method is intuitive. Most people can understand how one business can be worth a certain amount based on the already established sale price of a similar business.

Because each of these three methods defines value in a distinct way, valuators like Ezvaluator determine a company’s value independently using each method and then blend the results to get a single final result. Each method may be weighted differently in the final result based on its relevance to the company being valued. Ezvaluator employs this approach in its Benchmark Appraisal Report to ensure the end result reflects the most complete, up-to-date and accurate approaches to determining the value of your business.