By established convention, companies are usually valued on the business enterprise value basis. For publicly traded companies, this is the sum of the shareholders’ equity, less cash or cash equivalents, and the total value of debt. This represents the current value of the company regardless of the capital structure, i.e. what types of debt or equity capital the firm uses.
Private companies often sell in an asset sale transaction. This generally includes the value of its long-term assets, also known as furniture, fixtures and equipment (FF&E for short) as well as the intangibles such as business goodwill. Typically, the accounts receivable are retained by the seller, along with the company’s cash assets. Inventory is often valued separately and can be added to the asset sale value. Again, the value of debt is added back to the equity value of the company. That’s because in an asset sale, the buyer expects the company assets to be delivered free and clear.
On occasion, a company can be sold on a stock basis. In this case, the buyer assumes the firm’s liabilities. The equity value of the business in this case excludes the liabilities but includes all short-term and long-term assets.
Given this diversity of business values, you should consider advising the readers of your business appraisal report what type of business value you have determined. It could make a major difference if the the person reading your report mistakenly assumes that your analysis concludes the business enterprise value when in fact you have calculated the equity value. If the firm uses debt capital for financing operations, this is likely to understate the actual value and result in misunderstanding down the road.
Even if you use the recognized terms for reporting business value, be sure to spell out what is actually included in your results. Indeed, the specific description of what is included in your business valuation calculations is required by all major business appraisal standards.
Business people are sold on the usefulness of financial statement projections for company financial management purposes. Pro forma financials are the staple of corporate financial analysis. In addition, these pro forma projections form the basis for credit analysis and estimation of how much debt or equity financing the firm will need in the future.
You can run ‘what-if’ scenarios to see what types of pressure the company will experience should some key financial and sales parameters change. This is an excellent way to reveal potential risks facing the business.
Business valuation is about assessing future returns and levels of risk for the company. So financial modeling is at the heart of business value analysis, especially when you use the valuation methods under the income approach, such as the discounted cash flow technique.
Most financial forecasting models are sales driven, in other words they assume that majority of balance sheet and income statement items are in some way related to sales. For example, accounts receivable are typically set as a percentage of sales. The fixed assets can be modeled as a function of the sales level they are intended to support.
In your financial forecasts, you should distinguish between the items that are functionally related to sales and those that are driven by policy decisions. For example, the asset levels are typically assumed to be functionally related to the sales. You need to have certain assets to generate sales, such as levels of inventory.
On the other hand, the proportions of long term debt and equity can be seen as a policy decision made by the firm’s management.
To make sure your financial forecast can be used in business valuation, you need to handle the so-called plug in your model. That is the balance sheet item that is needed to make the model work. It meets the following financial statement requirements:
- Making sure the balance sheet, i.e. assets and liabilities, are ‘in balance’
- Ensuring the model correctly represents the company’s planned investments
Usually, the model plug will take one of these forms:
- Cash and cash equivalents
- Owners’ equity
Let’s say you choose cash and cash equivalents as the model’s plug. Mathematically, the balance sheet is in balance if the cash and cash equivalents plug equals the difference between the firm’s total liabilities and equity and its other current and fixed assets.
In the financial sense, this approach states that the company will not sell its stock, repay or raise additional debt. Instead, the business is expected to be financed by its own cash. This, of course, assumes that the company has enough cash on hand to fund its operations.
You can value the entire business and calculate its value which includes all of its assets. This brings up a question, do individual business assets have value on their own? The answer depends upon the reason for valuation.
Consider, as an example, a piece of machinery the business uses to produce its products. Chances are the machine can be sold to an equipment dealer for a certain sum. Thus, this asset has a market value and can be taken out of the production line to be sold.
This example points out two critical elements associated with asset values:
Note that the machine in our example above was both separable and marketable, thus its value could be easily determined. All you have to do is make a couple of calls to used equipment dealers to get an estimate of the fair market value.
Now let’s consider a rental agreement the company has signed, locking in attractive rental rates for a period of time. This is a valuable intangible asset as it puts a cap on an important business expense going forward. Is it valuable?
Asset business value depends on who values it
The answer is it depends on who is doing the valuation. For the current business owners, the rental agreement is definitely valuable. In fact, its value is determined by the amount of relief the company gets from paying higher rentals in the future.
On the other hand, the rental agreement may be non-transferable. So if the company came up for sale, the new owners would have to renegotiate the rental agreement and the new terms may not be nearly as attractive. If the business buyer values the company, the value of this non-transferable rental contract is zero.
This distinction is often missed by business people and financial advisers: for whom is the business value determined?
Once you answer this key question, you can address the elements of separability and marketability to figure out if the asset is worth anything on its own. A good example of non-separable business asset is trained and assembled workforce. If the company is sold, the expectation is the employees, at least some of them, will remain with the business. You can’t sell employment agreements on their own, so the workforce asset is not separable or marketable, at least not in a free market economy.
If the company owns an asset that can’t be transferred to another party, its market value can’t be established. Just like in the above example with the business premises rental, the value is limited to the current business ownership.
That being said, many business assets can be very valuable, i.e. they can be pulled out of the existing business operations and sold to someone else. Obvious examples are equipment and machinery. Other examples include intangible assets such as patents and trademarks.
You can value the patents by using the so called relief from royalty method. Basically, you estimate the typical royalty payments the company would have to make in order to license a comparable invention from an outside patent holder. The present value of the royalty payments needed would give you a fair estimate of what the patent is worth.
Asset replacement is another way to look at a business asset value. What would it cost the company to develop and put into use similar set of assets? Consider the costs and time needed to re-develop in-house software tools, or a set of procedures used to produce company’s products. You can discount these costs to the present time to estimate the value of such assets.
The takeaway on business asset valuation is this: while the entire company is usually assumed to be marketable and valuable on its own, the individual business assets may lack in one or both of these key value factors. When in doubt, always consider if the business assets have a real secondary market and can be offered for sale on their own. In addition, always ask for whom the value is determined.