My wife looks like a million bucks, and my business is worth the same." Would you agree to the first but not the second? How does someone arrive at the value of a small- to medium-size firm? A firm whose stock trades on the New York Stock Exchange can simply use the trading value of the stock, but non-public firms must use other methods.
"Whatever a willing buyer will pay determines the price" may be true, but for the sake of planning for the ultimate way to pay off a loan, sell stock to the employees or provide for retirement, the approximate market value is important.
The challenge is that there are a number of different methods to set the value, but each depends on the situation at hand. Common sense dictates that a business is worth more when sales are strong and the owner is ready for retirement and much less when it is having a fire sale due to a poor market or a tough economy.
Liquidation value: In a bank lending situation, for instance, the bank will lend money against a secured asset -- your business. He will use the estimated value of all assets under a forced sale. It is the "worst case scenario".
When a banker makes a secured loan he will only use the value of some of the assets, a semi-liquidation calculation. Accounts receivable and inventory are the favorites. Accounts receivable are set at 80 percent of the value of those that are outstanding 90 days or less. Those over 90 days old are worthless to the loan.
For inventory the value is generally set at 50 percent of what the banker would estimate is "current." For real estate, 80 percent of the appraised value is used. While these percentages may seem low, a true liquidation value of the business, however, would push these numbers even lower without counting deductions for auctioneer and legal fees.
Adjusted book: Price estimates are also necessary to obtain money from venture capitalists or to sell the stock to a new owner. These estimates are called the adjusted book value.
In negotiations between buyer and seller the estimates may substantially differ from each other due to the methods used. While the value of hard (real estate and equipment) assets is relatively easy to establish based on the historical cost and estimated useful life, the calculations for the total operations should include projections of the future earnings potential, market situations and industry shifts. The person who makes the evaluation must have a basic understanding of the business. This adjusted book process is called an earnings-based value.
The purpose of the buyer's investment will also influence the price. If your stock is to be sold to a new investor, the value may go up if the person will own a controlling percentage of all the stock, generally 51 percent or more. Conversely, if a buyer will only own 5 percent, the offer price will probably decrease.
Keep in mind that the percentage ownership may be of little consequence if the purchase is for investment income purposes only.
Price/earnings method: One well known price setting process is called the price/earnings method, which can be a challenge for a privately held company. Some research must be completed to find a number of other companies in your same line of business who have publicly traded stock. This information is best found at the library.
Your firm's bottom line is adjusted to add back all the perks which are built in, such as excessive incomes, extra travel allowances, club memberships, etc. To be even more realistic, the average of the past 5 years should be used. With this adjusted bottom line the price earnings ratio (P/E) is applied to get the value.
This is the point for negotiations when you, the seller, may want to be paid nine times the annual calculated earnings, which is the same as an offer to sell the business for an amount equal to nine years of net income. If the buyer will only offer five times earnings then you must negotiate to a common ground. Knowledge of the P/E ratio for a publicly traded stock will provide support for your offer price.
Replacement value: A relatively simple business valuation often used by insurers is the replacement value of the assets. This is similar to a basic policy any of us would have on our home or apartment -- how much would it cost to replace something and start the business again from scratch? Be sure to fully understand the business valuation process the insurance underwriter will use before the policy is signed.
Other factors: Regardless of the methodology, every business valuation must take into account the future earnings capacity of the company. An analyst will project the future profits for the business after certain assumptions about the industry and the economy have been made. The projections for the business will also be influenced by the analyst's regard for management's abilities and the industry's situation.