In most jurisdictions, private businesses are required to pay the so-called ad valorem taxes on business personal and real property. Most business people treat these taxes as a necessary evil – you have to pay them regardless of how well or poorly the company did in a year. You simply have to fill out the local assessor forms about the business property changes, additions and asset retirement, then send in the check.

Interestingly, most assessors do not appraise the business property at its true fair market value. This is a defensive tactic. If a business owner gets a tax bill that shows the business asset values as overstated, he is likely to object to the amount. It is harder to argue if the assessed values are below what the assets are actually worth.

It turns out that the assessed value of a business asset does not matter in so far as the tax bill is concerned. There are two key elements to a business property tax. First, is the assessed value. Second is the overall tax revenue the local government expects to collect. The tax rate is determined based on the overall property valuation and the revenue goal.

So it does not matter if your firm’s assets are appraised at 100% or 50% of their fair market value. The business property tax expense is exactly the same.

Since the tax revenues are split across the entire local asset base, it does matter if your business property valuation is relatively higher than that of other local companies. There are two reasons this may happen:

• You have overstated the values of your company’s assets.
• The assessor has not properly equalized the value of your firm’s assets in relation to other companies in the area.

In fact, business property tax bills usually do not detail the equalization rate applied to calculate your firm’s property tax burden. The assessor applies the effective equalization rate to all local companies in order to spread the business property taxes on an equal share basis.

The important part to remember is that the business property values and, therefore, the taxes are based on the asset values your company has reported initially. The assessor then calculates your tax bill based on the these initial asset values along with any adjustments for depreciation and inflation.

One point to bear in mind is that the assessor is unlikely to adjust your business property tax for any economic or technological asset obsolescence.

To minimize your business property tax bill, be sure to report the newly added assets at their true market values. As time goes by, make appropriate adjustments to the asset values as property is being used up and replaced.

If you are considering valuation of a company, private or public, the choice of valuation methods may seem bewildering at first. Business appraisers and economists recognize that there are three ways to value any company:

1. Asset approach – which looks at the company’s assets and liabilities.
2. Income approach – that establishes the company’s value based on its earning power and risk assessment.
3. Market approach – where you determine the value of a company in comparison to selling prices of similar firms.

Under each approach to company valuation you have the choice of methods, the techniques used to calculate the value. All company valuation methods usually fall under one of the above three approaches. Some may share characteristics of several approaches at once.

Here are the mostly commonly used methods for company valuation under each approach:

Asset based valuation methods

• Asset accumulation method
• Excess earnings method

The Asset Accumulation method lets you establish the value of a company based on the tabulation of the market values of its assets and liabilities. Sounds like a familiar balance sheet? Not quite. Using this method you would need to adjust the values of each asset and liability to market.

In addition, the method requires that you include many of the off-balance sheet assets and liabilities such as internally developed intangibles and contingent liabilities. Examples of the former are intellectual property and key supplier / customer agreements. The latter may include pending legal judgments and regulatory compliance costs.

The Excess Earnings method is actually a hybrid with elements from both the asset and income approaches. One of the greatest strengths of the method is the ability to determine the value of business goodwill. The most common implementation of this valuation method is known as the Capitalized Excess Earnings because it uses the capitalization technique to calculate the company’s goodwill.

Income based company valuation methods

All methods under the income approach come in two basic flavors: capitalization and discounting. The famous examples are the Multiple of Discretionary Earnings and Discounted Cash Flow methods. The difference is in what income measure is considered when calculating the company’s value.

The capitalization methods use a single measure of earnings and an estimate of company’s risk known as the capitalization rate. The discounting methods take an earnings forecast, usually over a number of years, along with the discount rate. If the company’s earnings grow at a constant rate both types of methods give you identical results.

Market based valuation methods

You can estimate your company’s value by comparison to similar firms in a number of ways:

Using a Comparative Transactions method where the comparison is made against actual business sales of similar private companies. The challenge may be in finding reliable sources of data that can be used for defensible business appraisals.

Applying the Guideline Public Company method. Here you opt for comparisons to similar public firms that resemble your subject company. Since public companies are required to disclose their financial condition as well as major transactional activities, data for comparison tends to be both publicly available and consistent.

Using the Past Subject Company Transaction method. If the ownership of the company being valued changed in recent past, you can review the selling prices of such ownership interests to get an idea of what the company is worth.

Regardless of the method choices you make for your company valuation, the results you get will depend on your assumptions and expectations. It is a very good idea to pick a few methods to make sure you haven’t missed an important point in your analysis.

If you need to determine the value of goodwill of a business or professional practice, the capitalized excess earnings method is an excellent tool. This asset-based valuation method, known as the Treasury method, is especially well suited for goodwill estimation for all types of privately owned companies.

Treasury method uses two rates of return

One important element of this technique is the use of two rates of return in the calculations. One is the so-called fair return on net tangible assets. The other is the capitalization rate used to calculate the value of goodwill from the business excess earnings.

Improper selection of these two rates is perhaps the most common source of errors in business valuation using this method. So it behooves you to choose these values with care.

Choosing the rates of return for your business valuation

Since the excess earnings method looks at the sum total of tangible business assets, it makes sense to use the firm’s discount rate as the fair rate of return.

The idea is that the business owners, acting as investors in their own company, expect the return on the committed capital to be commensurable with the overall business risk. That is exactly what the company’s discount rate captures.

The discount and capitalization rates are related. In fact the cap rate is just the difference between the discount rate and the firm’s expected long-term earnings growth rate.

This being the case, it is reasonable again to use the overall business capitalization rate when calculating the value of your firm’s business goodwill. The Treasury method accomplishes this by capitalizing the excess earnings.

Business goodwill needs to be a finite number

One final note on your business goodwill result. It is common practice to assume that the excess earnings can be capitalized over a finite number of years. So the cap rate should be limited to a number that does not drop below a certain threshold. The typical limits are 3 to 10 years. For example, setting the 10 year limit will give you the cap rate of 10% or greater.

One of the central valuation methods under the income approach is the Discounted Cash Flow technique. To apply this method in your business valuation you would need to work up the following key inputs:

• Forecast of business cash flows
• Discount rate measuring the business risk
• Business long-term value, known as the terminal value

While the future cash flows and business risk assessment usually come from the business financial plan, the calculation of the terminal value requires a leap of faith. The idea is that you can predict business earnings only so far into the future.

You may feel that the business will continue running as a going concern but have difficulty predicting its future earnings. The discounted cash flow method lets you get around this problem by including the terminal value in the calculation. This represents the residual value of the business beyond the earnings forecast period.

There are a number of situations that business owners or their advisors may handle differently in this respect. For example, they may have a clear plan toward selling the business and the kind of money the transaction will likely bring.

On the other hand, the owners may decide to wind up the operations after some time and either sell the remaining assets or use them up prior to the shutdown.

Each of these scenarios may greatly affect what the business is worth today. Other things being equal, the difference is in the terminal value of the company.

If the firm is to continue as a going concern, you can capitalize the future earnings accounting for the expected earnings growth rate and calculate the terminal value.

Alternatively, you can incorporate the future business selling price directly into your valuation. In other words, the residual business value to the current owners is the discounted future selling price.

If the business is to be closed after some time, then the terminal value is just the salvage value of the remaining business assets. If you do not expect significant assets to remain on hand at that point in time, then the terminal value is zero.

Example: Long term planning and business value

Let’s see how these considerations can affect the result of your business valuation. Consider an example company with the following 5 year net cash flow forecast:

• Year 1: $95,377
• Year 2: $101,231
• Year 3: $107,085
• Year 4: $112,940
• Year 5: $118,794

Note that the average cash flow growth rate for this business is 5.47% annually.

We further assess the business risk and calculate the discount rate of 29.58% and capitalization rate of 24.11%. Next, consider the business value under each long-term scenario as follows:

Case 1: Valuation of a business as a going concern

Here we make the assumption that the company will continue operating as usual past the earnings forecast period. The terminal value is then calculated to be $519,605. Applying the discounted cash flow valuation to these inputs gives us the following business value result:

Business value as a going concern: $397,913

Case 2: Valuation of a business that is sold at the end of the earnings forecast period

Under this scenario, the business owners believe that they can sell the business for $750,000 five years down the road. The resulting business valuation now becomes:

Business value: $460,978

Case 3: Business valuation for a company that is shut down in 5 years

In this situation the business owners opt to close the business at the end of the earnings forecast period. They intend to use up the business assets so that they will have no salvage value then. The company is basically worth the present value of the cash flows expected from the business over the 5 year period. Using the discounted cash flow method again, we get the following result:

Business value: $255,686

Business value depends on your assumptions

Note the sharp differences in the business valuation results we get under these different scenarios. Clearly, the decisions you make today can have far reaching consequences on what the business is worth.

Companies developing security software applications fall within the custom software industry sector. It is classified under SIC code 7371 and NAICS 541512.

Information systems security concerns in companies large and small are a major reason this sector of the software industry has experienced rapid growth in recent years. In 2011, over 49,000 US based firms have been responsible for over $65.4B in total annual revenues. The industry as a whole employs well over 555,000 professional and administrative staff.

Yet the vast majority of security software companies are considered small to mid-size businesses. The average firm produces about $1,500,000 in annual sales with a staff of just 12.

Business valuation of security software development companies

As with any software business, you have a number of well known valuation methods to value security application development firms. These companies are common acquisition targets so you can use the recent business sales as a guideline to estimate the value of a company in this industry.

These sales comparables are an important source of valuation multiples that you can use in calculating the business value in relation to a range of financial performance factors. Here is our short list of valuation multiples to consider:

• Enterprise value (EV) to gross revenues or net sales
• EV to seller’s discretionary cash flow
• EV to EBIT or EBITDA
• EV to hard assets such as Property, Plant and Equipment (PPE)
• EV to total business assets
• EV to book value of owners’ equity

Example: Using valuation multiples for security software company appraisals

Let’s pick a typical firm in this industry with the following financials to demonstrate the technique:

• Revenue: $1,500,000
• EBITDA: $250,000
• Total business assets: $1,200,000

We next apply the valuation multiples to the corresponding financial performance bases to calculate the business value:

As the above table shows, the calculated values can differ quite a bit. This depends on how our example business financials compare to its industry sector peers. For example, this company appears to be relatively asset rich for its level of revenues and profitability.

You may come across this situation when valuing a private business: the company owns substantial real estate assets in addition to business operations. By convention, businesses are appraised as though the premises were rented rather than owned. If the company owns its premises and does not pay rent to the landowners, you need to factor a fair market rental expense into its income statement.

Consider business and real property separately in your business valuation

This puts the company on an equal footing with its industry sector peers. Remember that business value is defined by business earnings. Since it is typical for companies to lease their premises, you need to consider the effect of this expense on the business cash flow and business valuation calculations, especially with such income-based methods as the Discounted Cash Flow.

What about the business owned real property? You should determine its market value separately, as though the property were put on the market to get the highest and best renter.

The net operating income (NOI) from this arrangement along with the capitalization rate define the economic value of the property. If the business were to be put on the market, along with its real estate holdings, the value of the package would be the sum of business and real estate values, considered separately.

Valuing a business and real estate together

One business valuation method that you can use for your calculations is the well-known Multiple of Discretionary Earnings technique. As you go through your valuation analysis, input the fair market value of the real property along with any other non-operating / excess business assets. The method then lets you calculate the valuation result than combines the business and real estate values.

When it comes to valuing a private business using market-based methods, one valuation multiple that stands out is the price to business revenues. Actually, there are two variants of this distinguished valuation tool:

• Price to gross revenue
• Price to net sales

In fact, there are a number of industry sectors where the price to sales valuation multiples are preferred. Here are the top ones:

• Professional practices, especially medical and dental practices
• Technology companies in high growth mode
• Manufacturing businesses, especially those in emerging market segments

With so many valuation multiples to choose from, why would business people and professional appraisers trust price to sales numbers more? Because in some situations this measure of business value is more reliable. Here are some scenarios when you may want to consider using the business revenues as the key basis to appraise a company:

Professional practice value is about client retention

Client retention is essential to preserve the value of a professional practice that is being sold. Essentially, the practice buyer is after the revenue stream of the practice and may have plans regarding profitability improvement or capital investments. Hence, the valuation multiples based on profits, say the practice net income or EBITDA, as less valuable when estimating what the practice is worth.

High growth company value depends on sales growth

Young growing companies can become very attractive if they manage to establish themselves as a leader in a market niche. Their ability to generate revenues in a highly promising industry sector is the major value driver. In this sense, the company’s revenue is a strong predictor of its success – that sheds light on how valuable the firm is.

At the same time, such companies may not yet have been optimized for top profitability. In addition, further business expansion may call for considerable capital investment. So, again, using valuation multiples based on profitability or current asset base is not as revealing.

Business value is driven by market share and revenue growth

The same argument holds for established manufacturing businesses that are successful in a new market sector. Imagine a company that has developed a strong customer following in one of the green industry segments.

Early entrants with a compelling product and service mix tend to grab market share and generate sales quickly. You can capture this key value driver by using the price to revenue valuation multiples when appraising such a company.

Income valuation methods to supplement your business appraisal

To round out your business valuation, do not forget to take advantage of other methods, especially those under the income approach. The Discounted Cash Flow method in particular is an excellent supplement to value a business based on earnings forecast and risk going forward.

Such expectation driven business appraisal is a powerful way to verify the business value estimates you get from the market-based valuation multiples.

Do you need to value a retail pet store? Here are some industry statistics to consider first:

Pet stores are classified under the retail industry SIC code 5999 and NAICS 453910. Pet retail establishments make up a large portion of the miscellaneous retail industry. In the US there are just under 169,000 such operations.

This retail sector creates a total of $58.8B in annual revenues, and employs some 732,900 people. However, a typical pet store is small business: producing an average of $400,000 in sales per year with 4 staff.

In fact, 97.7% of pet retail businesses have 24 or fewer employees. Together these small, local businesses generate about 68.7% of the industry total annual revenues.

Well-established, successful pet retail businesses develop loyal customer following. The result is highly stable earnings year after year. Such cash cow operations are attractive acquisition targets.

Hence, an excellent way to estimate the fair market value of your pet retail store is to study the recent sales of similar businesses.

Pet store valuation using multiples

You can choose a number of valuation multiples for your business valuation. The multiples are ratios that relate the selling prices to some measure of sold companies’ financial performance. Here are the typical valuation multiples used in pet store appraisals:

• Price to net annual sales
• Price to gross profit
• Price to net income
• Price to EBIT and EBITDA
• Price to seller’s discretionary earnings
• Price to total practice assets
• Price to owners’ equity

Consider using several of such valuation multiples for increase the accuracy of your business valuation.

Each multiple gives you a business value estimate that may differ depending on how your pet store compares to its industry peers. The result can be a range of values, from low to high. Alternatively, you can calculate an average of all the business value estimates together.

Example: pet store valuation using multiples

To illustrate, let’s take a typical privately owned pet supplies store with the following financial details:

• Annual net sales: $400,000
• Gross profit: $180,250
• Net income: $30,000
• EBITDA: $32,750
• Discretionary earnings (SDE): $85,000
• Inventory: $55,000
• Furniture, fixtures and equipment assets valued at: $40,000

We next select a set of reasonable valuation multiples and apply them to the financial figures above. The practice value results are then:

Note the result spread. This depends on how our example pet store compares to its peers across the financial performance parameters.

Other pet store valuation methods

As with other types of businesses, a properly done business valuation should include several business valuation methods.

Established pet store businesses can build up significant business goodwill. The Capitalized Excess Earnings valuation method is a good choice when valuing such companies.

Direct capitalization methods, especially the Multiple of Discretionary Earnings valuation method are an excellent choice for valuation of privately owned pet stores. This method offers you a very systematic yet intuitive way to calculate the business value based on its earnings and a set of key financial and operational performance factors.

Valuation multiples lie at the heart of business valuation under the market approach. Each business is different. Yet businesses in the same industry group, of similar size and ownership structure may share a number of important factors that drive their value.

If there are enough data on similar business sales, you can estimate the value of a company by comparing the recent business selling prices. Valuation multiples are ratios that relate the business selling prices to their financial performance. This relative measure of business value lets you calculate the worth of a similar business even if it has never been put on the market.

List of valuation multiples used

Professionals use a number of valuation multiples in their business appraisals. Here is the most common list, grouped by category:

Business valuation multiples based on revenue

These types of multiples are very common in valuations of professional practices and rapidly growing businesses.

• Business price to gross revenue.
• Price to net sales.

Valuation multiples based on profitability

Standard accounting profitability indicators are well known to business people, professional advisors and government agencies. They are often used in formal business appraisals, especially those requiring regulatory filings with the government agencies such as the SEC. Here are top ones:

• Business enterprise value (EV) to gross profit.
• Enterprise value to net income.
• Enterprise value to EBITDA or EBIT.

Cash flow based valuation multiples

Cash flow is the preferred basis for economic business value assessment. Not surprisingly, you will find a number of multiples that help you value a business based on its ability to generate cash flow. Here are some examples:

• Price to seller’s discretionary cash flow (SDCF).
• Price to net cash flow (NCF).

Valuation multiples based on business assets and equity

For asset rich firms in the manufacturing, distribution, and retail industry sectors business assets are usually important indicators of what the business is worth.

In addition, business people may want to know the difference between the book value and economic value of their ownership interests. Typical valuation multiples in this category are:

• Business value to total assets.
• Business value to fixed assets such as furniture, fixtures and equipment (FF&E).
• Business value to owners’ equity.

Choosing your valuation multiples

You have a number of options when choosing the right valuation multiples in you business appraisal. As with any method, the choices are dictated by the purpose of your business valuation and the specific value factors present in the subject business. Here are some thoughts to ponder:

You may choose to focus on the revenue growth potential when valuing a young growing company. The business may be generating respectable sales but not be optimized for top profitability. Some well planned operational changes may well improve its cost structure resulting in higher profits down the road. Valuation multiples based on gross revenue or net sales are a good choice here.

Established businesses being valued for merger or acquisition often rely on the EBIT or EBITDA based valuation multiples. Again, these accounting measures are well known. In addition, they help you value the company regardless of the capital structure used – something that is likely to change anyway following the transaction.

If you are appraising a privately owned business, cash flow is the typical basis. The economic potential of owner-operator managed companies is best assessed using the firm’s discretionary earnings such as SDCF. For larger firms being acquired by a single buyer or private equity firm the net cash flow based multiples are an excellent choice.

Using a number of valuation multiples

You can significantly improve the accuracy of your market-based business valuation by using a number of different multiples at once. You can then apply an averaging scheme to the results you get, or establish a range of possible business values, from low to high.

One of the central business valuation techniques under the income approach is the discounted cash flow method. It lets you calculate the business value based on three fundamentals:

• Business earnings forecast, usually annual cash flows.
• Discount rate which captures business risk.
• Long-term business value, known as the terminal value.

The standard discounting valuation formula assumes that the business cash flows occur at the end of each year. However, a business may generate a smooth income stream throughout the year.

Mid-year convention adjustment

The typical way to handle such situations is to discount the cash flows as if they occurred in the middle of the year. This calls for just one simple adjustment to your discounted cash flow valuation result, multiplication by this factor:

where D is the firm’s discount rate. You can calculate the equity discount rate by using the Build-Up model. If the company is financed by both debt and equity capital, use the weighted average cost of capital (WACC) iterative procedure.

Example: Comparing discounted cash flow valuations with and without the mid-year convention.

Consider a company with the following cash flow forecast:

Let us assume that the firm’s discount rate is 30%. The estimated long-term earnings growth rate is 5.53% which gives us the business terminal value of $5,124,129.

With these inputs prepared, we next calculate the present value of the business using the standard discounting and then adjusting the result for the mid-year convention as follows:

Business value, standard discounted cash flow method

Business value adjusted for the mid-year convention

The mid-year convention result gives the business value that is 14% higher than the standard discounting valuation.

The difference grows as the discount rate increases. This makes sense – the more risky the business, the greater the importance of receiving the cash flows as early as possible.