Ask any professional business appraiser and you will get an earful about the financial statements, adjustments and the true economic income estimation. Why all the fuss?
In a perfect world, you should be able to figure out business value by just using the company’s financial statements. After all, don’t the income statements and balance sheet capture the company’s financial performance? It turns out, not quite.
If you are not a seasoned accountant, here is a quick rundown on how financial numbers are reported for businesses. In the US, the Securities and Exchange Commission (SEC) requires that all public companies prepare and file financial statements in accordance with the so-called generally acceptable accounting principles, known as GAAP.
Trouble is, there is no one place you can go to in order to understand what GAAP is all about. So accountants have developed a de-facto understanding of GAAP that they all follow. Even though the Financial Accounting Standards Board (FASB) sets the rules, it is the practicing CPAs that interpret GAAP and file the financials with the SEC.
Now, the foundation of GAAP is known as historical cost. One key point for business valuation is that only the assets the company paid for are recorded on the books. CPAs can then trace all such recorded assets to the original purchase invoice. The system functions quite well as long as the assets are in tangible form such as the real property, machinery, office equipment and furniture. If it comes to an audit, you can find the actual physical assets and trace them all the way back to the original purchase invoice.
GAAP misses the value of intangible assets
So far, so good. If the prices of assets change slowly over time, and inflation is kept under control, the system works well. But what if your company is rich in intangible assets such as intellectual property? The patented software developed by the internal R & D may be the most valuable asset your company owns. Yet, it is not a tangible asset purchased from a vendor. So there is no real book record for it!
What do you think is more valuable from a company investor’s perspective? Office furniture or highly prized software design that generates sales?
In many companies today, the value of such intellectual property far exceeds the value of all the tangible assets combined.
GAAP cost basis misses the market value
Clearly, GAAP financial reporting misses a key point when it comes to business value. The standard was developed in an industrial age when dealing with intangible assets was not an issue. Under GAAP the best you can do is capitalize the cost incurred in developing your patented technology, but not its market value!
Financials are normalized for business appraisal
Correcting this picture in order to determine the company’s true market value is the job for business appraisers. One method that stands out is the asset accumulation technique. You start with the company’s cost basis balance sheet and normalize it by adding the values of assets and liabilities that are missing. The result is an economic balance sheet, one that captures the market values of all assets, whether they have an accounting cost basis or not.
GAAP serves the needs of CPAs who are conservative by nature. As long as the system allows the accountants to do their job well, they are happy. But when it comes to business appraisal, you need to make adjustments that reveal the true value of the company.
What type of business earnings do you use in private business valuation? The difference could be huge, the results misleading.
Public or private, business value is about returns at a level of risk you can accept. Risk is typically captured in the form of discount or capitalization rates. You can calculate these by using the well-known CAPM or Build-up models. But before you can run your business valuation calculations, the business earnings need to be estimated.
If you pick the discounted cash flow method, the earnings need to be forecast over some future time period, usually several years. Capitalization calls for just one earnings number that should represent the company’s earnings outlook.
Are accounting multiples good enough?
But what type of earnings should you choose in your calculations? The choices are many and confusing. If you look at typical market based valuations for public companies, valuation multiples based on the accounting metrics abound. Price to EBIT, EBITDA, net income, gross revenues or net sales are common.
Private business valuations: Addbacks, normalizations
Yet in private business valuations the typical choices are the Net Cash Flow, abbreviated NCF, and Seller’s Discretionary Earnings or SDE.
Business appraisers talk about the process of financial statement reconstruction or normalization to get at these numbers. Business brokers refer to addbacks.
The reason is that privately owned companies do not need to comply with financial reporting standards, like GAAP or IFRS, unlike the public firms. So one company’s EBITDA may very well be different from another business.
Public firms maximize earnings; private firms minimize taxable income
Creative financial management aside, private businesses pursue very different financial goals from their publicly traded counterparts. While a public company strives to maximize its stock price, and, therefore, earnings per share; the private business owners are mainly concerned with minimizing taxable income.
Private companies don’t pay taxes – the owners do
Private businesses are generally organized as the so-called pass through entities, such as the S-corporations or LLCs in the USA. The companies do not pay taxes, the owners do as individuals. This also helps minimize business taxes as the owners may have additional expenses they can offset against business income to reduce taxes.
Public firms do this by moving operations into tax advantaged geographies, or getting major tax breaks from local governments in return for sizable investments in their communities. If you are a typical small business owner, this is not the game you can play.
Aggressive depreciation skews the earnings for private businesses
A private business has the additional benefit of accelerating asset depreciation. This allows business owners to recover costs quickly. However, it skews the actual asset use and reinvestment picture. Your EBITDA may be affected by such ‘paper expenses’, the D and A in this acronym.
In contrast, public companies are under constant scrutiny by the government. They must clearly demonstrate how they use the invested capital in order to inform their investors properly. The result is typically a much more realistic picture of asset depreciation.
Friends and family borrowing is not commercial terms
Interest expense is also tricky. Private companies may borrow from family members, friends, or business owners themselves on the terms not available in the public market. Public companies borrow money from commercial lenders. Invariably, the terms of such loans represent the current market conditions.
When you compare publicly traded companies, you can review their financial statements that have been prepared by professional accountants, subjected to an audit, and are in compliance with the GAAP (Generally acceptable accounting principles). This is generally not the case for privately owned firms.
Moral: Use Net Cash Flow and Seller’s Discretionary Earnings
As a result, accounting measures of income such as EBITDA or EBIT are not suitable in private business valuations. The business earnings need to be normalized in order to reveal the company’s actual economic potential. The normalization process enables you to establish the company’s earning power. Given your risk assessment, you now have all the inputs required to conduct an accurate and realistic business appraisal.