Helping Business Owners Understand Valuation Approaches

Starting Point

Before any valuation can be performed, it is necessary to determine the actual value of the business’s tangible assets and its net income. In some cases, projected net income may also be necessary. The starting point in each case is the most recent financial statement.

The asset’s values begin with book value, and adjustments must be made for assets, such as machinery, that are over- or undervalued based on replacement cost. The book value reflects the undepreciated original cost. If the machinery is now worth more than the book value, the difference is added to the book value, and if less, subtracted. If there are undisclosed or contingent liabilities, book value should be reduced by these amounts; if there are any liabilities that will not be paid, such as loans to owners, then book value should be increased by them. With equipment, it might not always be easy to determine the value; in such cases, it is necessary to engage an appraiser if it is material to the overall valuation. Otherwise, simple estimates by the owner should suffice.

Premise of Valuation

There are two possible premises of a valuation: that the business will continue as is as an operating entity, or that it will be liquidated. For most valuations of a profitable business, the liquidation alternative should not be considered unless the assets are substantially underutilized and by themselves have values greatly in excess of what the business could be sold for based on its earnings. This is something that is not usually determined until the end of the valuation process.

Operating Income

With respect to the business’s net income, it is necessary to make adjustments to normalize the earnings based on what they would be if the business was owned or operated in a more normal or appropriate manner. An example is where the owners receive salaries greatly in excess of what an employee performing similar functions would receive. Other adjustments could be for above-market rent being paid to an owner who is also the landlord; fringe benefits above what would be considered regular for that type of business; advertising, marketing or public relations costs incurred for reasons of ego; moving, restructuring, legal, or special consultant costs that were onetime events and will not reoccur; or personal expenses that would be eliminated by a new owner. This produces a “normalized” net income, which is a starting point for any valuation. Individuals should be made to understand the process of normalizing income, since certain adjustments might indicate a lack of proper compliance with income tax reporting.

Purpose of Valuation

While official valuation reports can run more than 50 pages and contain numerous calculations, the valuation is ultimately an opinion based on certain facts and assumptions. In addition, many different values can result based on the purpose of the valuation, and this must be made clear before commencing. For example, valuing a business for estate tax reporting purposes is done differently than for gift tax purposes, even though these two issues are intertwined in many individuals’ minds. Furthermore, a valuation for a divorce would be done in a completely different manner than for executive compensation purposes, or, for that matter, for a sale to a buyer interested in working in the business. Still another method would be used for a partner’s buyout upon death, and possibly another for that same partner’s retirement.

The purpose of the valuation affects the standard of value used, which in turn determines the basis of the. Gift and estate tax valuations use the fair market value standard, while divorce uses fair value. Furthermore, the fair value for divorce is different from the fair value for valuing assets on an audited balance sheet. Likewise, a different standard is used for valuing employee stock options than for valuing built-in gains when a C corporation converts to an S corporation. With respect to divorce, the state the divorce is conducted in determines the standard. Determining the appropriate standard takes patience.

Assumptions Needed

Many assumptions are necessary for a valuation. In determining the normalized net income, various assumptions will have been made, as described above. Once the normalized net income is arrived at, the owner must decide whether to take a backward or forward look at the earnings. With fair market valuations, there is usually a requirement for some sort of average of previous years’ income. Depending on circumstances, it could be the previous two, three, four, or five years, with no account of the current year’s expected earnings (which would also be an assumption). Whether to use a mean or weighted average is another assumption. Assumptions must also be made to determine if projected earnings will be used, and those reports may need to be provided by the client or performed as a separate engagement.

Other assumptions include discount rates and capitalization rates. A discount rate is used to determine the present value of future earnings used in the valuation, while a capitalization rate is necessary to determine value based on the buyer’s or acquirer’s expected earnings. For example, if an investor expects a 15% return on his investment, the normalized net income should be divided by 15% to determine the business’s value. A higher capitalization rate will thus produce a lower value, and vice versa. Determining a capitalization rate can involve numerous variables, each of which is also an assumption.

Fair market value business valuations involve adjustments for minority or swing vote interests, as well the marketability of minority or noncontrolling interests. These adjustments are also assumptions, as is the decision to apply such adjustments.

Other Information

No valuation can be done without an understanding of how company is organized and operated: its capital structure, ownership, employment, customer and supplier contracts, leases, generation of sales, competition, key employees, special formulas, brand equity, warranty obligations, special customer or supplier relationships, industry situation and market share, competitive and disruptive pressures, and many other elements distinct to the company. A valuator must review all of these in addition to the financial statements and data.

Determining Value

Once all of the data is collected, reviewed, examined, and evaluated, assumptions are applied, and information is organized and tabulated, an estimated value can be determined. In the absence of an actual sale, this is no more than a guide to the value. To call it an “educated guide” would be a misnomer due to the number of assumptions used, but it indicates a best-case valuation.

Valuation Reports

CPAs can issue two types of valuation reports. A conclusion of value is an official opinion and carries the most weight of any valuation prepared by CPAs. For estate and gift tax purposes, divorce actions, and for many other purposes where it is expected that the appraiser will have to testify in court, this is the only valuation report that is acceptable. Another type of valuation report, a calculation of value, can be used for informal purposes, settlement discussions, determining a parameter or benchmark of the business’s value, as well as most financial planning purposes. AICPA members must follow the conclusion of value and calculation of value rules in the Statement on Standards for Valuation Services 1. CPAs who are not AICPA members should state in their reports what standards they are following, as well as if they have credentials from other bodies. In the absence of any credentials, it is difficult for an appraiser to establish credibility, but her body of experience in these matters would carry weight. To save on fees, many CPAs perform “informal” valuations, especially for financial planning purposes. These usually do not follow any standards, and accordingly might not contain all the procedures and steps necessary to obtain a reasonable valuation, possibly resulting in a valuation that would not be in the client’s best interest.