Archive for June, 2012

For valuation of companies that pay income taxes at the entity level the business appraisal needs to take this into account. In a vast majority of professional business valuations you are likely to see, the local (e.g. state) and national (e.g. federal) income taxes are combined into a composite income tax rate.

In the US, this can be around 35% – 40% of the pretax business income. Coming up with a greater level of precision in estimating the effect of income taxes on the business cash flow forecast would likely require participation of a highly skilled tax professional. In practice though, the effect of resulting adjustments to business cash flow is far less than the margin of error in the earnings forecast itself.

There are situations where you may need to involve an experienced tax accountant in order to assess the effect of income taxes on your earnings forecast. Most business appraisers though consider the composite tax rate assumption good enough.

Business Valuation of Pass-Through Entities

Many privately owned companies do not pay income tax at the entity level. The effect on business cash flow and, therefore, its value needs to be considered when valuing such firms.

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Asset approach, also known as the cost approach, is one of the three major ways to value a business. Formally, this approach relies upon the economic principle of substitution:

The business value equals the cost of recreating an enterprise of equal economic utility.

The idea is that two businesses that generate the same economic benefits for their owners are worth the same.

Note that the asset approach implicitly states that under normal market conditions there is no such thing as an irreplaceable business. For every company, however unique, there is another one that is just as valuable.

If you are in the market to buy a business, you will likely have several candidates to investigate. If your preferred acquisition target does not work out, you will probably move on to the next business down the list. There is always the next best thing in the business market.

Major asset based valuation methods

Asset based valuation approach offers you a number of ways to determine the value of any business. The most common asset valuation methods used in professional business appraisals are these:

The asset accumulation method bears a superficial resemblance to the familiar balance sheet. You create a compilation of the business assets and its liabilities. Next, you assign the values to each. The difference between the sum total value of all business assets and liabilities is business value.

Sounds simple? The devil is in the detail: each business asset and liability must be painstakingly identified. In addition, there should be a way to allocate value to each of these. Some of the line items you may need to work with never show up on the typical business balance sheet: internally developed intangible assets such as patents, trademarks and trade secrets as well as contingent liabilities which may include environmental compliance costs and pending legal judgments.

The excess earnings method is actually a hybrid technique borrowing from the asset and income approaches. In addition to looking at the tangible assets and a set of business liabilities, the excess earnings method also helps you determine the value of business goodwill directly. To do so, the method uses the business earnings as input showing its connection to the income approach.

This unique strength makes the excess earnings method the top choice when valuing established companies with considerable goodwill.

Examples include professional services establishments such as law and accounting firms, medical practices and engineering / architecture companies. The method is also very useful when valuing manufacturing businesses, and successful technology companies, among others.

Asset Business Valuation Method

Excess Earnings Method, known widely as the Treasury Method, is preferred in professional business appraisals whenever the value of business goodwill needs to be established. This is the case for successful services companies, professional practices as well as manufacturing and technology firms. The method is widely used in valuations for divorce.

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The key assumption behind the market comparable valuation methods is that the value of a business is revealed once you see what similar companies sell for. If a piece of business equipment has been sold in, say, the last six months for $350,000 then it is likely that we can get about the same if we were to put a similar machine up for sale today.

Of course, the actual selling price may vary based on the equipment condition and any unique features that make it particularly suitable for the buyer.

Note that we are not concerned about the cost of replacing the equipment. Nor are we interested in the potential income stream it can produce. We just check the market prices for similar machines. The idea is that the business sellers and buyers out there have already priced all this information in.

So business value is what someone is willing to pay for it. In this sense, your business valuation is a guess about what the business is worth to someone else. The real proof of any business appraisal is the actual price the business sells for.

Since no two businesses are quite the same, it is very likely that a given business selling price will be different from what the market comparison would suggest. Any company is a complex set of business assets and the unique way they are managed to produce income for the owners.

Business Valuation based on Market Comps