# Archive for March, 2008

When it comes to valuing a business, the business value number you get is always in today’s dollars. In other words, all business appraisals are done in the present.

Yet the key goal of business valuation is to assess the company’s earning potential and risk going forward. In this sense, your business appraisal is always forward looking.

No two business types stretch the dimension of business earning upside and risk more than these:

A “cash cow” business which produces steady income year over year. The company does so with minimal risk but shows moderate growth.

A high growth company that promises excellent growth and great returns in the future. At present though, the business may be unprofitable.

## So which business is worth more money today?

Let’s see how the well-known Discounted Cash Flow business valuation method lets you answer this question precisely.

## Example: business valuation of a cash cow and a rising star

For our “cash cow” business, we have the following net cash flow forecast in the next 5 years:

• Year 1: \$100,000
• Year 2: \$103,000
• Year 3: \$106,090
• Year 4: \$109,273
• Year 5: \$112,551

The earnings growth rate is an uninspiring 3% per year. However, because the company operates in a well-protected niche and stable industry, you estimate the risk to be quite low and calculate the company’s discount rate at just 15%. Beyond year 5, the long-term terminal value of the business is capitalized at \$966,062.

Our “rising star” high growth company shows a very different cash flow forecast. In the first year the company is unprofitable. It breaks even in year 2 and starts producing good earnings starting in year 3.

• Year 1: (\$100,000)
• Year 2: \$0
• Year 3: \$100,000
• Year 4: \$125,000
• Year 5: \$156,250

This is done at a very high earnings growth rate of 25% per year. However, this growth is achieved at considerable operational and market risk. Hence, you estimate the discount rate for this company to be around 35%.

Given the long-term growth and year 5 earnings, you determine the long-term (terminal) business value to be \$1,953,125. Five years from now, the high growth business would be worth about twice as much as the company with the steady income!

You can calculate both scenarios using ValuAdder Discounted Cash Flow business valuation.

The value of each business is based on the respective earnings forecast, discount rate and long-term value. Remember that we are interested in what each company is worth today. The results:

## Business value conclusion: high growth comes at a price

What this example demonstrates is that high business growth that defers business earnings may be worth less than a low-risk stable income stream.

In fact, our high growth business will have to demonstrate about twice the business earnings in year 5 to be worth the same as the “cash cow” company. Getting to that level of earnings fast may require considerable amount of additional capital and stretch the company’s ability to grow.

Knowing this, you can combine the two extremes into a winning business value-creating strategy:

1. Develop a steady, low risk income stream first. Early positive cash flow and stability of earnings translate into superior business value.

2. Focus on high growth opportunities going forward. Their risk may be justified by higher returns at a later time.

## Business goodwill valuation: handling negative values

Most business people expect that an established business is worth more than its asset base. This extra value is known as business goodwill.

In other words, you can determine your business value as the sum of its assets plus business goodwill.

The accepted way to estimate the value of business goodwill is to capitalize the so-called excess business earnings. You can use the well-known Capitalized Excess Earnings business valuation method, sometimes called the US Treasury method to do the job.

Once you determine the fair market value of business assets, you can calculate the value of business goodwill as follows:

• Subtract a fair return on business net tangible assets. The difference is the excess business earnings.
• Capitalize the excess earnings to calculate the value of business goodwill.

## Business goodwill value: positive or negative?

The value of business goodwill you get from above is positive for most established businesses. Occasionally, a business goodwill result can be negative. What can this mean?

• Some business assets are not fully used to generate income.
• The business is seen as high risk which calls for a high rate of return on business assets.

If you get negative business goodwill value, consider these points:

• Make sure you account for all business earnings correctly. See how net cash flow is calculated.
• Identify which assets are either overvalued or not fully used to produce these earnings. Adjust the asset values.
• Revisit your fair rate of return figure. See how to build it up to properly capture your business risk.

If you plan to buy or sell an online business, you will be glad to know that the market for privately owned Web based companies is alive and well.

In this active market, it is important to measure the value of an Internet business you have created or plan to buy. So what is your business worth?

## Internet business market value – directly from the market place

The answer is simple: with all the market bustle, there is plenty of recent data on Internet business sales. You can use these business sale comparables to come up with a quick yet defensible estimate of what your Web based business is worth.

The latest release of ValuAdder business valuation software, V3.5.10, makes this task a breeze. You can calculate the market value range, average and median business values using the valuation formula multiples for a number of Internet business types.

Business Market Values across 420 Industries

• Online publishers
• Search engine marketing agencies, Pay-per-Click and SEO
• Directory, information and subscription service sites
• Online auctions
• Internet entertainment sites
• Website design firms
• Hosting providers and IT services
• Software and technology development firms
• Internet telephony, VoIP
• And many more!

Valuing a Business based on Market Comps

## Business valuation for a click-and-mortar operation

If you run an off-line business as well as a website, you can use the ValuAdder Market Comps Tool to determine the value of a business across 425 industries – including service firms, restaurants, auto repair shops, retail, manufacturing, building contractors, and professional practices, to name a few.

## Internet business valuation – 3 ways

Of course, no Internet business valuation is complete without income and asset-based valuation calculations. With ValuAdder, you can cross-check your business market value results using the well-known Discounted Cash Flow, Multiple of Discretionary Earnings and Capitalized Excess Earnings methods to calculate the value of business goodwill and total business value.

Need to structure the terms of a business sale or purchase? You will find the Deal Check calculation very handy.

If you are an Internet business buyer, ensuring that the terms of your offer make financial sense is key to avoid costly mistakes.

If you are a Web based business owner, structuring effective terms for the business sale keeps you from leaving money on the table.

Businesses use a wide range of assets, both tangible and intangible, to produce income. One way you can create business value is to use specialized business assets.

A well organized kitchen makes a big difference to a restaurant. A manufacturing firm has production equipment that is fine-tuned to reduce costs and output quality products.

Needless to say, such special-purpose assets are very valuable because of their essential contribution to business earnings.

## Challenges in valuing specialized business assets: highest and best use

Yet valuing such business assets may be harder than it seems. The need to value business assets often arises when the business comes up for sale. The key question then is whether the business buyer intends to continue using the specialized assets for the same purpose.

If, for example, the business buyer plans to make operational changes, some special-purpose assets may require additional investment. If the buyer uses the cost approach to valuing these assets, their business value will be adjusted net of the expected additional outlays.

Put differently, the business buyer may not be putting the specialized assets to their “highest and best use”.

## Fair market value of special-purpose business assets

Since savvy business sellers and buyers tend to act in their best interests, specialized business assets do have fair market value. The reason: in the business market, there are alternatives.

What this means is that you are unlikely to spend more on an asset than the cost of a suitable alternative. If you are selling a business, you would consider several offers before making a decision.

## Alternatives, business value and the principle of substitution

This principle of substitution is a powerful economic force that influences the value of businesses and their assets.

## Unique assets and amazing valuations

If the asset is truly unique, the principle no longer applies. That’s one reason why works of art can command such unexpectedly high valuations.

Business assets and commercial property are not really unique – there is always the next best thing that will do. Existence of reasonable alternatives explains why values of business assets tend to gravitate toward the fair market value equilibrium.