THE ART AND SCIENCE OF BUSINESS
VALUATION
- By
Stephen J. Kerr
After all the workshops and seminars that I
have given over the years, and the hundreds of company owners that I
have talked to, I realize that business valuation is still a mystery
to most people. I am amused at the comments I hear like, "You can't
really ever know what a business is worth," or "My business is
so unique, no one could ever put a value on it, but me." Both of
these statements ignore the fact that professional valuators have had
decades to sharpen their tools to perform accurate business appraisals.
This is not a dart game.
Today, the profession of business valuation has
access to intensive training through organizations like the American
Society of Appraisers and the Institute of Business Appraisers to fine
tune their skills at determining the precise value of your company. In
this issue of M&A I wanted to both demystify the process of appraising
a company and to debunk some of the myths some people have towards the
process.
Experience has taught me that you can establish
a fair market value for any enterprise. A graphic artist working from
her studio, a gift and book rep group in Texas, a start-up software company
- all have measurable value.
An appraisal of any business is accomplished
through a process of comparing levels of income and asset value. A company's
profitability remains the single most important factor in most valuations.
All of the raw materials that make up your company
have a cost. Labor, overhead, inventory, capital, equipment and even
human relationships. All of these have a value associated with them.
No business is so unique that you do not have to use some of these "raw
materials" in your enterprise. In fact, if any of these elements are
missing you probably do not have a business ... you have a hobby.
Determining the value of a profitable company
is simply a matter of mathematics. The question becomes which value are
we measuring? The Investment or Strategic Value of a corporation might
be far greater than the Fair Market Value. It's a question of highest
and best use. Those who can profit most from acquiring a product, service
or company will pay the most. It is only logical.
The most difficult projects I face, come when
I must put a value on an unprofitable or start-up concern. There are
no profits to measure, and often a negative net worth on the balance
sheet. Is this business worth nothing? If it is worth doing, and it serves
an economic purpose ... there is value.
You appraise an unprofitable businesses by developing
realistic income and profit models going into the future. The value of
a money losing business or start up is tied to many intangibles - the
management's trackrecord, the quality of the titles being produced and
the market demand for the venture.
The following describes some of the favorite
methodologies that business valuators use when conducting a business
valuation:
Common among the most favored methods are: The
Market Approach, which compares a private company's financial performance
against its public company counterparts. The subject company's past financial
history is analyzed on a weighted average basis and a Price Earnings
Ratio is established by comparing it to public companies in the same
business. Why public companies? Simply because these are the only corporations
that the valuator has full access to. The final result is discounted
up to 50% to account for the private company's illiquidity. This method
works best for corporations with $3 million in sales, or more The
Income Approach is often used in tandem with The Market Approach,
and measures the present value of the company's future income stream.
The Income Approach relies on management's multiyear financial forecasts
(or crystal ball gazing) to estimate the present value of the enterprise.
This method is usually the investor's best tool for calculating expected
return on investment.
The Excess Earnings Method happens to
be my favorite valuation technique, because it employs a combination
of adjusted book value and earnings capacity. That means, information
derived both from the income statements and the balance sheet of the
company. I have often riled against the use of The Market and Income
Approaches - simply because they do not make direct use of the
company's balance sheet when appraising the business. I started in my
business valuations career seven years ago by appraising printing companies,
and even now, when I am working on the value of a film or book publisher,
I still want to bring the balance sheet directly into the appraisal process.
It sounds more complex than it is but to use
the Excess Earnings Method, you attach a monetary value or score (between
0 and 6) to each of about 20 factors of the business, derived from a
study of the operations, competitive position and management. (We call
the final average the "multiple") The company's excess earnings are computed
by subtracting about 15% of the company's net worth from their cash flow.
This 15% portion represents the return any business should earn from
their assets -simply because they are in business. The remaining balance
is the company's "excess earnings". The whole thing is multiplied by
the "multiple" and the sum is added to the net worth. I hope you followed
all that because it really is very simple. The Excess Earnings Method
often utilizes a lower "multiple" than the Market Approach. However,
it requires no discounts. It works great for printing companies and businesses
with a large asset base.
The Cost Approach is employed to great
effect on difficult or unprofitable businesses. We often must measure
what the net value of the assets are today, and how much it could cost
to replace those assets. If a Boston software company has developed 10
games, how much would it cost a San Antonio software company to create
similar quality games. Often we track the investment funds and measure
the profit making potential of that investment. Under the umbrella of
The Cost Approach we may use replacement value, liquidation value or
book value to estimate the current market value of the enterprise
or its assets.
Combinations and variations of all of these approaches
are considered when determining value: earnings, dividend-paying capacity
and book value all play a part. This article is aptly named, The Art
& Science of Business Valuation because it is both a mathematical
science and a valuators training, knowledge and experience that shapes
the final figure. Good sense and good data will always tell the story.
In the end, every valuator's job is to most closely
approximate "the price a willing buyer would pay and a willing seller
would accept, both being fully aware of the relevant facts."*
* Definition of fair market value.
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