You can measure the value of a manufacturing firm using a number of well-known methods under the market, income and asset approaches to business valuation. However, to get accurate business valuation results you need to focus on two key points.
1. Identify and include all income-producing assets in your manufacturing company valuation.
More so than most other business types, manufacturing firms use a large number of assets. Property, plan and equipment typically represent a large portion of the manufacturing company’s investment.
Off-balance sheet assets such as internally developed intellectual property are very common. Product and process technologies can be licensed to generate additional income streams which increase business value.
At the same time, a manufacturing firm may have some assets on the books that do not currently contribute to income generation. Other assets, such as plant capacity, may not be fully utilized to produce income. If fully exploited, the value of these assets can be substantial.
2. Base your business valuation on a realistic cash flow forecast and business risk assessment.
Accurate estimation of the income-producing capacity for a manufacturing business may be challenging. Yet it is essential in defining what the business is worth.
Manufacturing firms invest heavily in developing new products and processes. And all products have a finite life cycle. Without constant innovation, technology obsolescence sets in quickly, reducing the income derived from product sales.
The levels of investment needed, and the accuracy of sales projection make a major difference to the manufacturing firm’s income prospects. Market acceptance of new products and competitive response also affect how successful a product launch is.
In terms of valuing a manufacturing business, this requires that you capture these elements in your cash flow forecast and business risk assessment.
Recasting historic financial statements for manufacturing business valuation
To determine the value of a privately owned manufacturing company, you need to construct an accurate picture of the business assets and income. You do this through the process of recasting the historic balance sheet and income statements.
Balance sheet reconstruction for valuing a manufacturing company
Here are a few guidelines for recasting your balance sheet:
- Remove cash levels in excess of operating requirements.
- Remove uncollectible accounts receivable. Check the aging report.
- Adjust all inventory to market value, focusing on the work-in-process and finished goods levels. Remove obsolescent inventory.
- Adjust all long-term assets to their fair market value. In a business sale situation, include only those hard assets that will be included in the transaction.
- Determine the current value of any prepaid expenses.
- Remove shareholder loans.
- Value the business owned real estate separately.
- Ensure that all currently owed amounts are included in the accounts payable.
- Verify all accrued expenses such as payroll and taxes due.
- Determine the customer deposit levels and only include those that can be transferred to the business buyer.
- Remove loans from business owners.
- Remove any real estate loans.
- Identify any contingent liabilities that may not appear on the historic balance sheet. Examples are possible legal expenses, and regulatory compliance costs.
Recasting the company’s income statements and preparing cash flow forecasts
Your focus when recasting the historic income statements and preparing a future cash flow forecast is to show an accurate picture of the business earning potential. The key points to consider are these:
- Realistic revenue projections from sales of new products and services.
- Can historic levels be sustained in the future? Consider the product life cycle and competition offerings.
- Review the current sales order backlog against historic numbers.
- Check the accrual of customer deposits against actual product delivery.
- If some customers account for a larger percentage of sales, assess the likelihood of this continuing. Adjust your sales projections if sales to some large customers can be lost.
Cost of Goods Sold:
- Supplier stability and anticipated cost trends.
- Watch out for changes in inventory costing and direct labor accounting.
- Assess the risk of reliance on “single-source” suppliers.
- What prices and terms will the business buyer receive?
- Check and adjust for owner-discretionary spending such as auto, advertising, phone, travel and entertainment expenses.
- Make sure that there is adequate business insurance and account for any premium increases if needed.
- Remove any personal charges from the professional expenses such as legal and accounting fees.
- Identify all compensation components for the principal owner-operator. This is an important part of your seller’s discretionary cash flow estimation.
- Adjust the salaries of all other working owners to market rates. This is also known as the “manager replacement” adjustment.
- Check the rent expense. If the business sells and a new lease needs to be signed, your cash flow forecast should reflect this change.
Choosing the business valuation methods
With your financial statement adjustments and forecasts ready, you can choose your business valuation methods. Some of these methods are especially useful when valuing a manufacturing business:
Market-based valuation of manufacturing businesses
Under the well-known Comparative Transaction Method, you basically compare your business with similar manufacturing companies that have sold in the recent past.
There is a strong market for private firms in many segments of the manufacturing industry. Pricing multiples derived from such business sales can help you determine the fair market value of your business in a very compelling way.
For small manufacturing firms, the pricing multiples of choice are based on the business revenues and earnings. In other words, you can estimate your business value by applying such multiples to your own business revenue or earnings.
Income-based business valuation: Discounted Cash Flow and Multiple of Discretionary Earnings methods
The Discounted Cash Flow method is a common way to value manufacturing companies. You can obtain very accurate business valuation results based on your business cash flow forecast and the discount rate, which captures the business risks. You can determine the discount rate using standard cost of capital models such as the Build-Up or CAPM.
The Multiple of Discretionary Earnings method is another choice when valuing a small manufacturing company. You can get excellent valuation results while accounting for a broad range of business financial and operational factors. To estimate the business value, this method requires a single-valued estimate of seller’s discretionary cash flow as its earnings basis.
Asset-based valuation of manufacturing business: Capitalized Excess Earnings method
A well-known Capitalized Excess Earnings method is a frequent choice to value manufacturing firms under the Asset approach. In addition to determining the total business value, this classical method lets you determine the value of business goodwill.
You can also use your valuation analysis results in order to allocate the business purchase price across the assets. Proper purchase price allocation is an important tax-minimization strategy following the business purchase.