Take a look at a professional business appraisal report and you will see a discussion of the current trends in the industry and expectations going forward. No business operates in a vacuum and economic conditions, especially emerging trends in the industry sector, make a big difference to what a company is worth.
Think about a growing company in an expanding industry with great profit potential and few large competitors who could dominate the market. Compare this to a declining industry controlled by a handful of deep pocketed mega-firms and major regulatory hurdles looming on the horizon.
The effect of such industry trends often far outweighs the overall economic conditions as it has the most direct influence on the company’s ability to compete.
When valuing a business, you need to pay careful attention to the industry trends and analyze how the company plans to rise up to the challenge. This requires a careful review of management, key staff, financial strength of the firm, its product and service competitive position. Your valuation report should help the reader see how the company fits into its market and why it will continue to be successful.
This analysis underlies the assumptions you make when calculating business value. Regardless of the actual methods you use to come up with your business valuation conclusion, the results should be based on sound assessment of the company’s industry and its prospects going forward. Cranking out numbers that ask your reader to suspend disbelief will not cut it.
If you are looking to appraise a business, looking at market evidence to support your conclusions is very useful. After all, the market is the final arbiter of what a company is worth. Short of test driving the market by putting your company up for sale, looking up recent business selling prices is the next best thing.
So far, so good. But the answer you get is only as good as the data you are able to gather. The old adage of ‘garbage in, garbage out’ applies to business valuations as well.
You may be tempted to delve into data sources touted as treasure troves of valuable data by their vendors. Comparing your company to similar firms that actually sold recently could help you work up a set of valuation multiples to estimate your business market value.
The devil, as the saying goes, is in the details. High quality data on private companies is scarce. Aside from filing tax returns with the Federal and local government, private companies are not obligated to disclose their financial and operational data to anyone. In fact, most private business owners consider such data highly proprietary and confidential.
So where do the data resellers get their data from? Usually, private company sales data comes from participating business brokers. While some brokers may disclose the details of their transactions, most consider such data their competitive advantage, and keep it under lock and key. When business seller prospects look around for a broker to sell their business, those with the most knowledge of the market tend to attract future customers.
The result is that most private company sales never get published. If you consult a data source on private business sales, you are likely to see only a small fragment of the deals actually made.
Most business brokers are sales people. Many lack the financial reporting skills and may report data that obscures the actual financial picture of the company. There is no compliance requirement with financial reporting standards, such as the Generally Accepted Accounting Principles or GAAP, as is the case for public companies.
Private business owners are famous for their skill at creative accounting in order to minimize taxable income. That’s why business appraisers spend considerable time adjusting company financials before appraisal. Since data on private companies does not include detailed background information, it is very difficult to adjust reported financials to reconstruct a true picture of company’s financial performance.
The result is your valuation multiples can be quite misleading.
As the saying goes, if something looks too good to be true, it probably is. If you doubt the valuation multiples you get by crunching the numbers obtained from a data reseller, it’s time for a ‘second opinion’. The best way is to source data on small capitalization public companies in the same industry. These firms are subject to the rules that mandate consistent financial reporting and full disclosure of the company’s current situation and prospects.
To make an ‘apples to apples’ comparison to a private company, adjust the valuation multiples you get for lack of marketability. The factor, known as DLOM, accounts for the relative reduction in business value because a private company cannot sell its stock freely to the public.
The USPAP standards, published by the Appraisal Foundation, cover every element of valuation for real, personal, and business properties. When it comes to reporting your business valuation results, it’s worth consulting Standard 10.
The Standard does not dictate the choice of form, format or style in compiling valuation reports. This is left to you as an author. The important point is the content. This makes sense as business appraisals address a wide range of audiences and situations, each with its own preferences.
To comply with the USPAP Standard 10, your report should state clearly all the assumptions, special considerations, and sources of information you have used in conducting your business valuation. The idea is that your intended readers should have enough to understand how you came up with your conclusions.
Appraisal and Restricted Appraisal report options
The latest Standard 10 makes a distinction between two major options: an Appraisal Report and a Restricted Appraisal Report. The latter is only intended for the client. Whenever other parties are going to be reading the report, the Standard 10 requires that you follow the more general Appraisal Report option.
The key difference is the depth and type of information you provide in your report. It is one thing to create a valuation just for your client, who is very familiar with the company. You can assume a level of understanding of the business specifics that is not available to outsiders. For example, a lender or investor looking to put money into your client’s company would likely require a lot more disclosure to make up their mind.
Avoid one-size-fits-all boilerplate reports!
If you do prepare a full blown Appraisal Report, be sure to indicate who the intended readers are. Everyone’s needs for information are different and a ‘one-size-fits-all’ does not work in business valuation.
Elements of USPAP Standard 10 compliant appraisal report
The key elements you need to include in a standard-compliant report are these:
Identify the client and any other recipients of the report.
State the purpose of the business valuation.
Discuss what is being valued, such as business assets included in your analysis.
State if the valuation is done on a controlling interest basis.
Indicate if there is any limitation as to the marketability of business assets.
State the date of your appraisal and the reporting date, if these are different.
Outline the scope of your analysis, including the sources of information researched and used.
Describe the approaches and methods used for calculation of business value and explain how you reached your value conclusion.
Explain any unusual circumstances and conditions that influenced your valuation.
Use all three valuation approaches
A USPAP Standard compliant valuation should use all three valuation approaches. That is to say, your analysis should look at business value from the Asset, Income and Market perspectives. If you decide to omit any of these major approaches, you should explain it in your report.
For example, you may be appraising a pioneering technology company that has no equals in the marketplace. It may be reasonable to forgo the use of the market approach methods as no reliable comparables are available.
Don’t forget to sign your report and mention anyone else who may have helped in your valuation. Clearly state the scope and limitations of your analysis so that your readers know what to expect. Your business appraisal report is the finished work product and represents the quality of your work.
Part of business appraisal is assessing the value of business assets. This is especially important if the company is for sale and the purchase price needs to be allocated across its asset base.
Business equipment values are typically established by market comparison. A business machine is valued based on its functional utility and condition, regardless of where it is located and who currently uses it.
The secondary market for used business equipment is well established. Equipment dealers do business in just about any kind of machinery a company can require. As a result, knowledgeable dealers have a pretty good idea of what a given machine is worth.
A company can make a choice of getting a new piece of equipment or finding a used machine that is cost effective and can perform the same function. The comparison boils down to the age, condition, and utility relative to the price of new versus used equipment.
If you are valuing business assets, the first stop should be a few equipment dealers. These intermediaries are usually happy to provide pricing information for free because the inquiries keep them abreast of who and why uses the machinery. This could generate a useful contact for future business deals.
Equipment auctions are another source of pricing information. When businesses are dissolved, their assets go up for sale. The prices paid at such auctions offer you direct evidence of what the market values for similar equipment are. You can even trace the age of sold machines based on the model and serial number information published by the auctioneer.
Just as with the company as a whole, market values of business assets can change over time. Be sure to pay attention to the timing and relevance of comparable sales when working out the values of your company’s machinery and equipment.
Figuring out the actual values of business assets is a common task in business appraisals. Pick up the property records in a typical company, and you are looking at the book values. Sounds easy, right?
Welcome to the real world. The fact is that business assets can and do disappear, while being on the books. On the other hand, some valuable assets can be in use while not on the books at all.
Don’t expect that this difference comes out in the wash. Your accountant may want to offset such imbalances, but two wrongs don’t make it right. How do business assets wind up on the company’s books? Usually, your accountant keeps records of business assets using their original cost of purchase less depreciation.
What this book value does not represent is the true fair market value (FMV) of the asset. To make matters even more interesting, the fair market value can be estimated on the premise of the asset in use or in exchange. The first assumption is that the asset will continue being used in business operations. The second is that the asset will be offered for sale. The value may differ by quite a bit.
The key point is that the price you paid for a piece of equipment or software application years ago may bear no resemblance to what the asset is worth today. Technological obsolescence has really changed the game in asset valuation. Just because a custom software cost you, say, $100,000 in 2000 does not mean its value is anywhere near that today.
Purchase price allocation calls for business asset valuation
Even so, there are examples in business appraisals when current fair market values of some business assets are close to their book values. This is more likely to be the case if you are valuing the entire company and the assets are expected to be in use. If the business is offered for sale, purchase price allocation across the assets is one scenario when accurate asset valuation is needed.
Market value of business assets – another perspective
If the company plans to divest of some of its assets, you may find that the market place has a very different idea of what these assets are worth. This comes up when business assets are viewed as a collateral against a bank loan. Your lender is not interested in using the assets. Instead, the likely selling price in the event your company defaults is important.
Liquidation value – when assets are sold at an auction
The appraisers call this the liquidation value. It is established at an auction attended by the equipment brokers or other companies looking to get usable assets at a discount. You can bet on the selling prices being lower than the book value in these situations.
Does the value of a company depend on which country it operates in? The answer is yes, and here is why.
Business value is about risk and return. In other words, what makes a business valuable is how much money it makes given an acceptable level of risk. Investors, including business owners, look to put their money into business ventures that promise reasonable returns, both on their money and of their original investment.
Why business values differ by country
When sizing up business risk, the country’s economic and political conditions matter. Consider operating a company in a well run, developed economy such as Western Europe or North America. Political situation and the laws governing commerce are well understood and enforced. Financial markets are highly efficient and liquid. If you invest in a public company, you can unload your holdings in a few moments and move your money into a different investment.
The situation in less developed or politically troubled countries may be very different. The rule of law may be confusing or hard to discern. Exporting your money may well be fraught with difficulties or be very expensive. Bribes and protection rackets could plague the unwary investors. Your erstwhile business partners could turn out to be plain crooks.
Global financial markets abhor such instability. If the investors as a whole see systemic problems in a given country, they usually vote with their feet and take their investments to safer havens.
If you are adventurous, you may give investment in an emerging economy a shot. After all, risk and reward go together.
Unsurprisingly, the global investment community has a way to assess just how risky a business investment is in a given country. Consider how the discount rate for business valuation is built up. This discount rate captures the risk of your business investment. Note the equity risk premium, or ERP for short, in the equation.
Equity risk premium and country risk premium
For advanced, stable economies such as the USA or Western Europe, the ERP is measured by the returns on a major equities index, such as Standard and Poor 500 (S & P 500). The countries rated by the major credit agencies at the top of the scale get the Aaa rating. What this means is that investing in such countries is about as good a bet as investing in the broad portfolio of companies covered by the S & P 500 index.
Put differently, business investment in the USA, Canada, or Germany is no more risky than the equities market as a whole. Such advanced economies do not have any additional risk premium by country.
However, business values in less developed or stable countries is more risky. If you choose to invest in a company in many South American or Middle Eastern countries, your investment carries an additional country risk premium. How high the premium is depends on the risk spread of the particular country.
Example: business values in advanced vs developing countries
How does this country risk premium affect business values? Lets take an example of two companies, each generating $300,000 in net cash flows and growing at an annual rate of 5.47%. Both companies are debt free, so their cost of capital is just the equity discount or cap rate.
Let’s further assume that both companies are small, under $50M in market capitalization, and offer professional engineering services. The first company, based in the USA, has the equity discount rate made up of these parts:
Risk Value, %
Risk free rate (based on US 10 year Treasury yields)
Equity risk premium
Country risk premium
Small company size premium
Industry risk premium
Company specific risk premium (CSRP)
Equity Discount Rate
This gives the total equity discount rate of 24.35% and capitalization rate (cap rate) of 18.89%.
The second company in our example is based in Argentina, the country rated B3 by Moody’s. The country risk premium is around 9.3%, which gives us the total discount rate of 33.65% and cap rate of 28.19%.
Difference in business valuation by country
We next use the constant growth direct capitalization business valuation method to figure out what each company is worth. Remember, the only difference in this scenario is the country risk premium. Here are the results:
Business value of the US-based company
Business value: $1,675,230
Business value of the Argentina-based company
Business value: $1,122,506
As you can see, the difference in business value is considerable. Given a choice, any rational investor would go for the US company due to its lower risk. The Argentina based company would have to throw off more cash increasing its returns in order to compensate the investors for its higher risk.
Whether you are buying or selling a private business, establishing its market value is critical to a successful transaction. Depending on which side of the transaction you are, you may need business valuation for these reasons:
Determine a reasonable selling price
Support your asking price
Screen businesses for sale to select promising acquisition targets
As a reality check in a business acquisition negotiation
Finding the right business selling price
In the minds of business owners, the best selling price is what meets their personal or business goals. It may be a retirement package or cash needed to get into a new venture.
The point to remember is the actual value of a business has nothing to do with the owners’ goals. It is an economic concept that rests on the business financial and operational outlook. Even historic performance is of little value except as a guide for estimation of the business future prospects.
If your business valuation disappoints, there is work to be done before the business goes on the market. You would need to review the key business value drivers and see what you can do to increase the valuation in order to meet your exit strategy objectives.
Increasing business earnings, putting a professional management team in place, or reducing key customer concentration can all go a long way toward increasing your business worth as well as making the company a more desirable acquisition target.
Is the asking price right?
No other piece of the business for sale puzzle causes more contention than the asking price. Sellers want the highest price possible, while buyers look to get the business on the cheap.
In a business sale, a reasonable price and terms will make or break a deal. A solid business valuation is your ticket to getting the negotiation off on the right foot. A business selling price that is backed by careful analysis is far more likely to lead to a successful deal.
Screening business for sale targets
One way to avoid the frustration of endless haggling is to screen business for sale listings. Doing this quickly and efficiently is the sure way to avoid fruitless debates with the sellers who refuse to budge. You can run quick valuation calculations, comparing the target companies to the actual selling prices, or estimating the multiple of discretionary earnings the seller expects.
If the target looks overpriced, consider moving on to more attractive opportunities.
Price justification – the reality check of business selling price
If you ever saw a business offering memo prepared by a good business broker, the suggested price and terms are usually included. The question is whether the deal matches the needs of both the buyer and the seller.
Such deal checks are important as they let both parties know what terms are acceptable. Regardless of the business valuation result, a business sale must address the needs of the actual buyer and seller. No two buyers have the same expectation of return on their investment, the same skill set or ability to recruit key employees. In addition, financial strength of the buyer can make a lot of difference as to the amount of down payment or ability to raise a loan to fund the business sale.
If you are considering a dental practice appraisal, here are some interesting industry statistics:
There are over 133,000 privately owned dental practices in the US alone, classified under the SIC 8021 and NAICS 6212. Dental practices are a large part of health services and generate around $104B in annual revenues growing annually at 11.6%.
Yet an average dental practice is a small service business – employing a staff of 6 – 7 and producing some $787,000 in annual sales. Revenue per employee is about $119,000. Dental practices employ some 882,700 staff.
Dental practice valuation methods – comparable practice sales
Practice sales happen regularly so there are plenty of comparable data to use for valuing a dental practice. There are a number of valuation multiples to choose from, each giving you a different way to determine the practice value. Here are the top ones most often used to price a dental practice for sale:
Surprised by this list? Well, the traditional way to assess a dental practice value has relied upon the net sales or gross annual revenues. However, the market for dental practices is quite dynamic and pricing trends change over time.
We keep an eye on the spread of actual practice selling prices from the average. This is handily captured by the coefficient of variation – the smaller this number the tighter the selling prices cluster around the mean. If you want to estimate your practice value, use the valuation multiples with the smallest coefficient of variation first. This means that practice buyers out in the market rely on these multiples more often when pricing acquisitions.
Recent dental practice sales data show that the gross profit based valuation multiples can give you the most accurate estimate of current practice value. In fact, its coefficient of variation is just 0.39 compared to 2.39 for the net sales based multiple.
Example: How to price a dental practice using multiples
Consider an average private dental practice generating $300,000 in annual net sales, having a gross profit of $275,000; discretionary cash flow of $100,000; and market value of all invested capital, which includes the practice assets and long-term liabilities, of $85,000.
Let’s take reasonable values of the respective valuation multiples for use in our value calculations:
Sale price to gross profit: 0.7.
Sale price to total invested capital: 2.
Sale price to net sales: 0.6.
Sale price to discretionary cash flow: 1.7.
Applying these valuation multiples gives us the following practice value estimates:
Based on gross profit: $192,500.
Based on total invested capital: $170,000.
Based on net sales: $180,000.
Based on discretionary cash flow: $170,000.
This gives us the average practice value of $178,125.
By convention of professional practice appraisals, the value includes all tangible assets and practice goodwill. It does not include cash, accounts receivable, liabilities or real estate. The value of earnouts set aside as a contingent part of the selling price, if present, is also excluded.
Recent sales of private dental practices are an excellent source for estimating your practice value. See how to value a dental practice based on its gross revenues, net sales, profits, EBITDA, cash flow and assets.
In the real world comparisons rule. We compare products, services, features and prices all the time. Price per square foot is the yard stick used by the real estate industry to compare properties. In a world of substitutes it seems there is always the next best thing out there.
But how about this: can you compare a one of a kind painting by a famed artist to somebody else’s work? Probably not. Reason is simple: a work of art is not the same as another. There are no substitutes for the real thing.
In business valuation, the situation may be quite complex as well. While many companies can be compared to their industry peers, some businesses are unique enough to defy comparison.
Imagine, for example, comparing Google to figure out its value in the early 2000’s before the company went public. There were no other businesses who offered the kind of search engine technology Google became famous for. If you tried to use market comparisons, you’d be matching the proverbial apples and oranges.
Indeed, professional appraisers know that market based comparisons may be misleading. After all, each business is unique. It is precisely its specific value set of drivers that determine its true value. Things like technology, business relations, skills of the company’s staff, and relationship with its customers tend to play a significant role in how it competes. No two businesses are ever the same.
Yet market comparison is based on the simple assumption that businesses operating in the same industry are interchangeable. If you know the selling price of several companies out there, you can estimate the value of your firm. Well, yes and no.
Market comps are good for initial business value estimates. It is easy to see how valuation multiples you get from sold businesses can be applied to your company’s revenue, asset base, EBITDA or net income to figure out what your company may be worth.
Market evidence is also useful if your business valuation comes under fire. Examples are legal disputes, or challenges by the tax authorities. If you can furnish proof of companies’ selling prices, your business value analysis gains support from the actual market place.
However, as the saying goes, there are lies, damn lies, and statistics. Market valuation is based on statistics collected either by yourself or someone else. The stats may be very misleading, depending on who and how collects and analyzes the market data.
Private business sales data is a case in point. Usually, such data is collected on a voluntary basis by business brokers. Only a fraction of the actual business sales ever get disclosed to the business sale data vendors.
Business people and brokers are not required to report private company sales to anyone. Most of such sales never get reported. Business owners may consider their acquisition strategy highly competitive. Brokers may view their knowledge of the market place as a key advantage and keep their deal statistics to themselves. What you see is just a sliver of the actual deal flow.
In addition, most business brokers are not financial reporting experts. Be wary of the financial numbers as they are not reviewed, let alone audited by a financial accounting professional. That is one reason private business financials require adjustment or normalization before you can value a company.
For these reasons, many business appraisal experts tend to approach the market valuation methods with caution. One way to get better quality data is to examine small cap public companies or private company acquisition deals done by public firms. Such transactions must be reported to the authorities, such as the US Securities and Exchange Commission, under law. In addition, the financial numbers must comply with the standard GAAP format and be audited by licensed accountants.
So your comparison is more likely to be “apples to apples”. But what about the difference between the public and private companies? Business appraisers use the discount for lack of marketability to adjust the valuation multiples from public company sources. Fortunately for your business valuation, the difference is visible in the market place – just check the prices of restricted company stock and freely marketable shares of the same firm. This measure of price reduction gives you an idea how much the investors discount the value of assets that have limited marketability.
Remember that market comparison is but one approach to business value. To uncover what your company is really worth, you need to apply the various methods under the income and asset approaches. In particular, the income valuation helps you delve into the value drivers that create business value. This type of analysis is as unique as the company itself.
Ask any professional business appraiser and you will get an earful about the financial statements, adjustments and the true economic income estimation. Why all the fuss?
In a perfect world, you should be able to figure out business value by just using the company’s financial statements. After all, don’t the income statements and balance sheet capture the company’s financial performance? It turns out, not quite.
If you are not a seasoned accountant, here is a quick rundown on how financial numbers are reported for businesses. In the US, the Securities and Exchange Commission (SEC) requires that all public companies prepare and file financial statements in accordance with the so-called generally acceptable accounting principles, known as GAAP.
Trouble is, there is no one place you can go to in order to understand what GAAP is all about. So accountants have developed a de-facto understanding of GAAP that they all follow. Even though the Financial Accounting Standards Board (FASB) sets the rules, it is the practicing CPAs that interpret GAAP and file the financials with the SEC.
Now, the foundation of GAAP is known as historical cost. One key point for business valuation is that only the assets the company paid for are recorded on the books. CPAs can then trace all such recorded assets to the original purchase invoice. The system functions quite well as long as the assets are in tangible form such as the real property, machinery, office equipment and furniture. If it comes to an audit, you can find the actual physical assets and trace them all the way back to the original purchase invoice.
GAAP misses the value of intangible assets
So far, so good. If the prices of assets change slowly over time, and inflation is kept under control, the system works well. But what if your company is rich in intangible assets such as intellectual property? The patented software developed by the internal R & D may be the most valuable asset your company owns. Yet, it is not a tangible asset purchased from a vendor. So there is no real book record for it!
What do you think is more valuable from a company investor’s perspective? Office furniture or highly prized software design that generates sales?
In many companies today, the value of such intellectual property far exceeds the value of all the tangible assets combined.
GAAP cost basis misses the market value
Clearly, GAAP financial reporting misses a key point when it comes to business value. The standard was developed in an industrial age when dealing with intangible assets was not an issue. Under GAAP the best you can do is capitalize the cost incurred in developing your patented technology, but not its market value!
Financials are normalized for business appraisal
Correcting this picture in order to determine the company’s true market value is the job for business appraisers. One method that stands out is the asset accumulation technique. You start with the company’s cost basis balance sheet and normalize it by adding the values of assets and liabilities that are missing. The result is an economic balance sheet, one that captures the market values of all assets, whether they have an accounting cost basis or not.
GAAP serves the needs of CPAs who are conservative by nature. As long as the system allows the accountants to do their job well, they are happy. But when it comes to business appraisal, you need to make adjustments that reveal the true value of the company.