Residential and commercial real estate appraisal firms comprise a large segment of the real estate services industry. Classified under the SIC code 6531 – 9901 and NAICS 531320, there are some 14,000 such companies operating in the industry in the US alone.
Together these professional services firms generate just over $5.8B in annual revenues employing more than 36,900 people that include real estate appraisers, managers, and support staff. Yet an average firm in this sector is small – with the annual revenue of about $415,000 and 3 staffers.
Business valuation of real estate appraisal companies
Appraisal firms serve the essential function of establishing the value of assets in the real estate industry. For many business development requires lasting relationships with local and regional lenders and real estate agents. Successful appraisal companies tend to create strong bonds with their referral sources that contribute to a steady stream of new and recurring business.
Solid earnings and profitability make these companies highly desirable acquisition targets. So if you need to value an appraisal company in your market, comparison to the recent sales of other firms in the industry sector is an excellent place to start.
if you plan to use the market approach to valuing your appraisal company, valuation multiples are the typical tools. As a rule, the multiples let you calculate the enterprise value of your company based on the selling prices and financial performance of companies similar to yours.
Here are the common valuation multiples to consider in valuing an appraisal firm:
Example: Valuation of a real estate appraisal business using multiples
As an example, let’s analyze an average real estate appraisal company with these annual financials:
- Revenue: $200,000
- EBITDA: $95,000
- SDCF: $145,000
- Total business assets: $180,000
Using the valuation multiples obtained from similar appraisal firms we can calculate the business value as follows:
|EV to net sales
|EV to EBITDA
|EV to SDCF
|EV to total assets
|Average Business Value
You may notice quite a bit of variation in the results using the different valuation multiples. This depends to a large extent on how the subject company compares to its industry peers. For example, a higher business valuation based on EBITDA may point to an appraisal company that is more profitable than its competitors.
Business Valuation Using Multiples
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.
Business Valuation – Treasury Method
If you are valuing a private business for any reason, the market approach should be an essential part of your analysis. There are a couple of methods you can use to establish the value of a privately owned firm:
- Comparative transaction method
- Guideline public company method
To use the comparative transaction method you basically develop a set of valuation multiples by observing the recent sales of private businesses that are similar to yours. These companies should be involved in the same market sector, be about the same in size, and show similar financial and operational attributes to the firm being valued.
The main challenge with using the comparative transaction method is gathering enough reliable data on such comparable business sales. Here are the main problems you are likely to face:
- Private business sale data reporting is not required by law, many deals go completely unreported.
- Business financials for private firms are not subject to financial reporting standards such as GAAP. This affects the reliability of your valuation multiples.
- When debt financing is hard to come by the deal flow for private business acquisitions slows down. So there are fewer recent transactions to compare against. This has certainly been the case in the recent economic environment as investors shied away from doing more risky deals.
- The reported data are not subject to review by independent financial accounting entities. This is quite unlike the reports on public companies.
In contrast, there is plenty of reliable data on business sale transactions involving publicly traded firms. These transactions are usually reported to government agencies, such as the Securities and Exchange Commission in the US. The filings are made along with the audited financials so the valuation multiples you get are pretty reliable.
However, the guideline public companies, even small ones, are usually far more marketable than their privately owned counterparts. This reduces the investor risk and makes business ownership interests more valuable.
Given this, what is the best practice you can adopt when using the market-based business valuation methods?
Combining the comparative transaction and guideline public company methods may be a good choice. You can gather enough data on private business acquisitions that you consider reliable. Where such data are insufficient or missing, consider using the guideline public companies that closely resemble your business.
This works quite well for the mid-market sector because many of such private firms are managed similar to the public companies. Once you have calculated the desired valuation multiples for your comparison, do not forget to adjust them for the lack of private company marketability using an appropriate DLOM (discount for lack of marketability).
Using this combined approach should give you enough tools to do a market based value comparison for just about any private business. As a rule, the market based valuation results are reported in the Low – Median – Average – High format.
Business Valuation using Market Comps