Archive for March, 2018

One of the well established business valuation methods, the capitalized excess earnings technique has a long and storied history. The method is described by the United States IRS in its Revenue Ruling 68-609. Unfortunately, the ruling does not specify what it means by the net tangible asset value, a key input into this valuation method.

The business appraisal profession has not formed consensus on the preferred way of estimating the net tangible asset value. Instead, there are several commonly used alternatives:

  1. Gross business assets net of accumulated depreciation, also known as the net current value.
  2. Net current value of the financial and tangible assets less current liabilities.
  3. Net current value of tangible assets minus all liabilities.

Most business appraisers adopt the second definition when valuing a business by the capitalized excess earnings method. This is not to say that the other definitions are less acceptable.

What’s more, the definition you use is not all that important to the results you get with this valuation method. The end result is always the indication of value the business owners hold and as such it should not be affected by the particular definition of the asset value.

How can this be the case? Remember that the capitalized excess earnings method uses two rates of return: the fair rate of return on the net tangible assets and the capitalization rate used in calculating business goodwill. Depending on your choice of measuring the net tangible assets, these two rates of return can vary.

The important part of applying this valuation method correctly is not to dwell excessively on what comprises the asset values. The key is consistency across all choices you make in your calculations.

In other words, the measure of net tangible assets should be consistent with:

  • The choice of the fair rate of return.
  • The selection of the excess earnings cap rate.

Make sure your choices match, and the method will provide a supportable estimate of business value, including its goodwill.

Take a look at a typical professional business appraisal report. You will see that a number of valuation methods are used to establish business value. In fact, all business appraisal standards, e.g. USPAP and AICPA SSVS No 1, require that you use all three approaches whenever possible. If you do not, you need to explain why your valuation has omitted one or more approaches from consideration.

A sensible business person can ask: what is the best method to use in business appraisal? Often, the market comparables offer the most supportable evidence of business value. However, the question is how comparable your subject company is to other, similar businesses? Apples and oranges comparisons do happen.

The asset approach is very helpful as long as no significant technological or economic changes have been at play in the market. In addition, business assets should be easy to evaluate as to their physical condition and residual value. Let’s say the equipment or software the business uses have been leapfrogged by new advances in technology. Old machinery or out of date software applications may not be worth much in such cases, so applying the asset approach methods could lead to erroneous valuations.

The income approach methods let you put on an investor’s hat. The biggest challenge is the need to forecast the future financial results for the business. No one has the crystal ball, and your valuation using such methods as the discounted cash flow is only as good as your earnings projections. The assumptions you make drive the results.

Regardless of the valuation methods you choose, business appraisal is an expression of opinion. If your valuation engenders trust, your readers are likely to rely on the answers. When in doubt, consider a second opinion. A different pair of eyes may offer a different view of the business and what creates business value.