If you want to get a top quality business appraisal, consider using several well-known business valuation methods.
Such a multi-method business valuation is standard in professionally prepared appraisals. Since each method represents a different view of how business value is measured, reviewing the results from several different methods gives you a comprehensive picture of what the business is worth.
In practice, you can choose some valuation methods over others because they are more suitable for your specific situation. Here are the typical method choices used for valuing established service firms:
Using market comps to value a service business
Successful companies in the services industry sell often. Hence you can do valid market comparisons to recent business sales to see what your business is worth.
The valuation multiples are ratios that help you estimate the market value of a business based on the actual selling prices of similar firms and your company’s financial performance measures. Business value is usually measured against the firm’s revenue, profits, cash flow, EBIT, EBITDA, business assets or owners equity.
Valuing a company by direct capitalization of earnings
Smaller service businesses, especially those with mostly recurring revenues, can be valued using the Multiple of Discretionary Earnings method.
Discounting cash flows to determine business value
For larger firms or those experiencing significant earnings fluctuations over time, the Discounted Cash Flow method may be more appropriate.
Valuation of business assets: tangibles and goodwill
Business goodwill can be a big part of the total asset base for service companies. To determine the value of goodwill, consider using the Capitalized Excess Earnings method, also called the Treasury Method.
Establishing business value
The results you get by using the various business valuation methods may differ. This is quite normal since each method uses a different set of rules to determine business value.
You can use your results to establish a range of business values, from low to high. On the other hand, you can average your business value results and come up with a single number. Both techniques are very common in professional business appraisals.
You can use a number of well-known business valuation methods to come up with a very accurate assessment of the company value.
One of the most difficult situations that often call for a business appraisal is divorce. Just about any jurisdiction considers business ownership interest a property that is part of the marital estate. As such, it must be distributed among the spouses.
In the US, the family courts follow two standards on how the property in the marital estate is to be divided:
- Community property
- Equitable distribution
Under the community property standard, all assets acquired during a marriage are treated as jointly owned by the married couple. They are thus divided into equal parts upon divorce.
Those jurisdictions that adopt the equitable distribution standard may or may not treat the business ownership interests as equally divisible. The courts have considerable discretion when deciding which party gets what share of the property.
Business valuations at different dates may be needed
In some cases the courts may treat business ownership acquired separately as part of the marital estate. To determine if the business value has appreciated during the marriage, the court may require that two business appraisals be performed:
- Initial valuation of the business at the beginning of the marriage.
- Re-valuation of the business at the time of divorce.
If the business value has increased over time, as demonstrated by the two business appraisals, a spouse may be able to claim part of that value, especially if that spouse was actively contributing to the business.
Needless to say, business value changes over time. In a lengthy proceeding, the valuation date can make a big difference to the amount of the final property distribution. Ask your lawyer if the court is likely to accept the business value:
- As of the marriage date
- On separation
- When the divorce is filed
- At the time of the court proceedings.
How business value is measured in a divorce
To make matters more interesting, courts do not have one standard of value. In reality, the following main standards of business value have been used in divorce cases:
Under this standard of business value, the argument holds that the divisible property should be valued at what it is worth to its present ownership, i.e. the married couple.
Fair market value
The proponents of this well-known standard maintain that one spouse should not be compelled to pay more or less than what the business can fetch if put on the market.
Used less often, this standard of business value requires an in-depth analysis of the business fundamentals to determine what the company is worth.
Defined by the legal system, this standard tends to be subject to the court’s interpretation. In fact, the fair value of a business may be equivalent to any of the above standards of value, depending on the jurisdiction.
Business valuation methods for divorce
As in most situations that call for a business to be appraised, you have a number of choices among the three valuation approaches:
- Asset – based on the values of business assets and liabilities.
- Income – based on the company’s earnings outlook and risk.
- Market – where the firm’s value is established in comparison to the sales of similar businesses or professional practices.
Business goodwill valuation in divorce
In many cases involving ownership of established businesses and, especially, professional practices, the question of business goodwill is of major concern.
A common business valuation technique used in marital dissolution situations is the Capitalized Excess Earnings method. Known as the Treasury Method, this technique offers a consistent way to determine the value of business goodwill and total business value.
This is important because of the way a particular court may handle business goodwill. Here are some common possibilities:
- Treat business goodwill as part of the marital estate and, therefore, distributable among the parties.
- Split the goodwill into the personal and institutional parts and handle only the institutional portion as distributable.
- Exclude business goodwill from the marital estate altogether.
Since business goodwill is often a large part of the total business value for many professional service firms, the amount and handling of goodwill can make a major difference to the final settlement!
Use of multiple business valuation methods is typical in divorce cases
It goes without saying that a comprehensive, defensible business appraisal is critical in divorce situations. Using a number of established business valuation methods, you can ensure the value of a business is accurately determined and can be defended in court.
Under the income approach, the courts consider both the capitalization and discounting valuation methods. Generally, direct capitalization valuation, such as the Multiple of Discretionary Earnings method, is best suited for companies with a track record of stable earnings. The Discounted Cash Flow method is the preferred choice for valuing young businesses or firms whose earnings vary considerably over time.
Market comparisons to recent sales of similar businesses offer an excellent and highly defensible basis to value your business. In cases of privately owned businesses, comparison to similar private firms is the preferred technique, known as the Comparative Transaction Method.
Defensible business appraisal is a must in divorce
More business appraisals are thrown out of court due to insufficient evidence or supporting information than any other reason. It behooves you to get all the facts together and review any business valuation critically if it is destined for a family court.
Discounts to business value
Depending on the jurisdiction, your business valuation may need to be adjusted for these factors:
See how a set of standard methods can be used to create a highly defensible business appraisal in a divorce situation.
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Classified under the SIC code 8011, the primary care physician practices are part of a large professional health practitioners service industry. In fact, there are over 373,000 medical practices in the US alone.
The industry as a whole generates some $202B in annual revenues, and employs over 3,000,000 professional and office staff. However, a typical medical practice is small business: producing around $600,000 in annual sales with an average staff of 8.
Medical practices tend to generate highly stable earnings due to the repeat business that arises out of an established and loyal patient base. As a result, established practices are a frequent acquisition target. Selling prices of similar physician practices offer you an excellent way to estimate the market value of your own practice or one you are interested in acquiring.
Market based practice valuation using multiples
In order to estimate the value of a medical practice, you can use a number of valuation multiples. Derived from recent sales of similar practices, the multiples relate the actual selling prices to the practice financial performance measures. The typical valuation multiples used in appraisals are:
- Selling price to net annual sales
- Price to gross profit
- Price to net income
- Price to EBIT and EBITDA
- Price to total practice assets
- Price to owners’ equity
It is a good idea to use a number of such valuation multiples for accurate business valuation. Each estimate may differ depending on how well your specific practice does compared to its peers. The result is a range of values, or some weighted average of all the practice value estimates together.
Example: using valuation multiples to value a primary care medical practice
Let’s consider a typical private medical practice with the following financials:
- Annual net sales: $600,000
- Gross profit: $585,000
- Net income: $80,000
- EBIT: $82,500
- EBITDA: $84,000
- Total practice assets valued at: $250,000
- Book value of owners’ equity: $11,000
For this example, we pick a set of reasonable valuation multiples and apply them to the financials. The practice value results are as follows:
|Price to net sales
|Price to gross profit
|Price to net income
|Price to EBIT
|Price to EBITDA
|Price to total assets
|Price to owners equity
|Average Practice Value
Note the considerable variation in the results. That’s because our example medical practice compares less favorably with its peers when it comes to the owners’ equity measure and profitability.
Other business valuation methods to consider
To be defensible a medical practice appraisal usually relies on a number of business valuation methods. Since physician practices tend to create considerable business goodwill, the Capitalized Excess Earnings valuation method is a common choice.
Practice goodwill valuation: a common requirement in divorce cases
This is especially so in cases of marital dissolution in those jurisdictions that treat professional practice goodwill as part of the marital estate. You may have to split the goodwill into the personal and institutional parts depending upon the way the court in your jurisdiction handles the distribution of goodwill assets.
Direct capitalization techniques such as the Multiple of Discretionary Earnings valuation method are another common choice for valuing owner-operator managed physician practices. The method provides a very consistent way of calculating the practice value based on its earnings and a set of financial and operational performance factors.
Valuation using a Set of Standard Methods
If you are considering an outside investment for your business or looking to put money into a promising company, business valuation is surely to be one of the key data points in your decision making.
Significant investments are usually made in order to achieve some strategic goals such as increasing the business revenues, entering a new market or developing the next generation products.
Business valuation – a forward-looking exercise
The value of the business is thus driven by its future earnings. It also depends on the level of risk the company is likely to face as it pursues its plans.
Perhaps the most widely used business valuation methods for investment purposes are the income-based discounting techniques. The best known of these is the Discounted Cash Flow method. It enables you to determine the business value today, known as the present value, based on three fundamental inputs:
- Future earnings forecast over some period of time, e.g. 5 years.
- Discount rate which captures the business risk.
- Long-term or terminal business value – or what the business will be worth at the end of the forecast period.
Savvy investors usually are very good at assessing the company’s prospects and risk. Since they consider a number of investment projects, they have an idea about the kind of return on investment they expect.
Put another way, they see the discount rate as the rate of return they require to become interested in a business investment.
Comparison of business value and investment – Net Present Value
One common technique these investors use is the Net Present Value calculation. It combines the Discounted Cash Flow business valuation with a direct comparison to the value of the proposed investment.
If the difference between the business value and the amount of investment is positive, the investment makes financial sense.
A special case is when the business value is equal to the investment value. The discount rate that makes this happen is known as the internal rate of return, or IRR for short. At this rate of return the business creates precisely the amount of value that justifies the investment.
Internal rate of return as a decision making tool
You can use the internal rate of return as a screening tool for a proposed investment.
If you are a business owner considering an outside investment, you should know both the amount of investment and the rate of return the investor expects. You can use the Net Present Value calculation to see if your business can grow in value to make the cut.
If you are thinking of investing in a company and have the size of investment in mind, then you can use the Net Present Value calculation to see if the business can create enough value to meet your required rate of return on investment.
Using Net Present Value in a number of what-if valuation scenarios
Time value of money can make a major difference here. You can run a number of scenarios with different cash-out assumptions. Is an early exit a better strategy than waiting longer as the business value grows? The Net Present Value calculation helps you make such important decisions in a precise, fact-based manner.
ValuAdder gives you a set of standard tools to determine the value of a business, structure an acquisition deal, and make sound investment decisions.
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