M—Business Valuation
There are many reasons why the owner of a closely held business must have some idea of the value of his business:
- When obtaining loans a higher, yet realistic, value could result in increased credit.
- If the reasonableness of compensation to an employee-stockholder is challenged by the IRS, knowing the value of the business will be helpful.
- In determining a price for the business when it is sold upon death, disability, or retirement.
- For estate planning purposes, the higher the value, the greater the potential estate tax.
- For estate planning and business continuation purposes, it is important to know the value when selling or gifting interests.
Valuation is an art; it is not a science. With the closely held business, the concept of valuation is often elusive. Pat answers rarely exist. However, with many businesses, “capitalizing” expected earnings can be a useful starting point for determining fair market value.
For example, we know that assets, plus the talents of good management, are expected to produce earnings. Assume that a business had assets of $1,400,000 and liabilities of $400,000. By subtracting liabilities from assets, we can determine that book value is $1,000,000. This is the net worth of the business, which is often referred to as stockholder’s equity. Also assume that the business has earnings of $220,000.
The first step in capitalizing expected earnings is to determine what rate of return an outside purchaser would expect on his investment. Assume that, after a careful consideration of the risks inherent in this particular business, the expected rate of return is determined to be 12 percent. If the sales price were set at book value, or only $1,000,000, expected earnings would then be $120,000. This means that there are excess earnings of $100,000, which should be reflected in the sales price as goodwill.
Goodwill is determined by deciding how much a purchaser should pay for these excess earnings, which are the product of such intangibles as reputation and market position. A careful consideration of both the age of the business and the likelihood of continuing excess earnings might reveal that the purchaser should pay for five years of excess earnings, or $500,000. By adding this $500,000 of good will to the $1,000,000 of book value, we get a fair market value for the business of $1,500,000.
Book Value
Many approaches to valuation require a consideration of “book value.” Simply stated, book value is assets less liabilities, or the net worth of the business. However, because assets are often carried at substantially below their fair market value, care must be taken to assure that book value is adjusted upward to reflect accurately the value of these underlying assets. This adjustment in book value results in an adjusted book value.
For example, land purchased many years ago is likely to have appreciated in value, yet it is often carried on the books at the original purchase price. Machinery and equipment may be depreciated for income tax purposes, yet be worth substantially more than is shown on the books (when carried at its depreciated value). If the LIFO (last in, first out) method of inventory valuation is used, the value of inventory will likely be carried at below market value. Because of this,
book value produces a valuation that is often below fair market value for most types of businesses. Generally, this is not recommended as a method for buy-sell valuation.
This can be seen in the following example:
1000 units purchased at $1.00 on June 1 $1,000
1000 units purchased at $1.50 on July 1 1,500
1000 units purchased at $2.00 on August 1 2,000
Total cost of inventory $4,500
Less 1000 units sold on August 2 (charged
to inventory at $2.00 per unit) (2,000)
Remaining 2,000 units carried at $2,500
But to replace these units it would cost $4,000
Inventory is undervalued by $1,500