Archive for the 'Business Valuation Tips' Category

If you are valuing a business using the income based methods, creating a viable earnings forecast is essential. Your business valuation result depends on your ability to accurately predict the income stream and assess business risk going forward, not an easy task.

What do you value – Business highfliers or cash cows?

No one has a crystal ball in business. Any number of circumstances can affect business prospects and have a material impact on its earnings. On the other hand, some companies operate in a protected niche mitigating uncertainty and ensuring the profits for the foreseeable future. These are the famous cash cow businesses, an investor’s dream come true.

So while an earnings forecast can be credible for a cash cow business, the same approach may fail when estimating future earnings for a high tech start-up.

What options are out there to create a reliable set of earnings forecasts for a company? The answer is, unsurprisingly, it depends.

Linear regression model for cash cow businesses

For the cash cow business that you expect to continue running much the same as in the past, an excellent earnings forecast model is the well-known linear regression. Under the assumption that historic trends accurately predict the future, you essentially project business revenues and expenses based on the company’s historic track record.

Visualize plotting the revenues and expenses on an X – Y chart. Draw a straight line through the historic data set into the future to read off the anticipated numbers. This is the linear regression model in a nutshell.

But what happens with the new businesses without a reliable history of earnings? Or a company undergoing significant changes such as new investment or change of business strategy? In such cases historic trends may be either non-existent or plain misleading.

Sales driven earnings forecast models

Time to roll up the sleeves and get to work developing a more realistic earnings forecast model. Most such models are sales driven. Based on the management’s plan and knowledge of the business and its industry, you create a revenue forecast.

Let’s say the company is expected to generate a certain level of sales in the next year, then continue to grow the sales level at 5% per year. Don’t forget to check the industry sector growth trends so as to stay within a realistic range of possible growth rates.

The business expenses, both cost of goods and fixed expenses can then be forecast as a percentage of revenues. This gives you the gross profit and net income forecast. You can use the same approach in order to estimate the future needs for current and fixed assets investment such as working capital, property, plant, and equipment, and financial capital.

Uncertain business prospects – creating best case, worst case earnings forecasts

The situation may get really interesting if you anticipate several likely outcomes for the company. Let’s say there is a possibility of substantial regulatory compliance outlays that may become a drag on business earnings. Or a government agency approval needed to enable the company’s new product sales.

You can create several what-if earnings forecast scenarios to capture each potential future outcome. Early approval creates the opportunity to generate high level of sales early on. Your earnings forecast should reflect this scenario. Higher business earnings in early years are sure to translate into higher business valuation result using the discounted cash flow method.

Conversely, delays in product introduction or pricing pressures from competition are likely to depress the earnings forecast. Re-run your discounted cash flow valuation with this cash flow stream to see how the business value changes.

Business valuation as a strategic value building tool

Having several business valuation results for each anticipated scenario gives you a range of values for the business. Remember that the discounted cash flow valuation gives you the present value, or what the business is worth today. You have translated future expectations into a set of numbers relevant right now.

Such what-if valuation analysis is extremely helpful if the business management must make critical decisions on their strategy. Don’t like the numbers? Now is the time to review your business strategy and make value enhancing changes.

Then re-run your business valuation to see the difference.

This group of business assets is of increasing importance to business value creation. Here is the short list:

  • Trademarks and service marks
  • Non-compete agreements
  • Website domain names

Trade marks and service marks are generally protected intellectual property. Businesses often seek their registration, such as the Federal trademarks issued by the US Patents and Trademarks office (USPTO).

Website domains are subject to domain registration rules. They often are a hotly contested commodity as businesses increasingly seek valuable online presence.

Non-compete agreements are enforced as commercial contracts that enable companies to operate in a protected market niche.

Intangible assets are sources of income

Importantly, these valuable intangibles can be licensed to others in exchange for a royalty income stream. Imagine the value of well known brands in generating business earnings. Customer recognition of some trademarks may be worth a fortune because it can generate additional income from their name while the rights to the company’s own products and services are protected.

In a business M & A transaction, such brand names are broken out into a group of intangible assets alongside business goodwill. During business valuation, each of these intangibles has a value assigned to them.

Business intangible assets may have a long life span

Historically, such intangibles were deemed to possess a limited life span. These days, business people recognize that trade name values actually grow over time. Thus, many trademarks may be seen as having an indefinite life. The earlier amortization rules do not seem to be appropriate for such assets.

Impairment test for handling intangible asset values

The Financial Accounting Standards Board (FASB) now provides for an impairment test when handling the marketing intangible asset values, similar to handling business goodwill.

What this means to you, is that the business intangible assets must be valued under the new rules. However, you do not need to write them off, unless the asset has a clearly defined life. This would be the case for term non-complete contracts which need to be amortized accordingly.

Business valuation is a constant challenge for the business people and professionals alike. While many security analysts do not have the accounting background, they often engage in valuing companies.

Professionally managed firms, especially public companies, must adhere to the consistent financial accounting and reporting rules such as the GAAP mandated in the US by the Securities and Exchange Commission (SEC).

SEC discourages private discussions between the public company management and independent security analysts these days, so digging up additional information beyond the filed GAAP financials is not easy. Most significantly, the company’s financials disclosed to the public do not provide much guidance on the values of company’s intangible assets.

From the asset approach perspective, business intangible asset value is potentially a very significant contributor to the value of the business enterprise. So how can an analyst estimate the value of a business in the absence of information on the valuation of the patents and trademarks, internally developed technology, skilled workforce, distribution channels, and customer lists?

If you are skeptical about the ability of a valuation expert to come up with an accurate business valuation without such information, you are not alone.

Many seasoned analysts know this and defend their view of business value by claiming the understanding of the key value drivers for the target companies. In other words, an experienced analyst develops an insight into the underlying business assets that are not explicitly valued in the disclosed financial and operational statements.

Less experienced analysts could arguably be swamped by the flood of data on a company and fail to make sense of all the ‘moving parts’. They feel that the accounting statements they have access to are about all they can handle in order to estimate business value.

So there you have it. Analysts tend to develop their opinions based on both the information available as well as their ability to glean the additional details on what creates business value. The conclusion is only as good as the credibility of the business appraiser.

Fundamental to the business valuation process is the need to make assumptions about future events. What the business is worth today depends upon future cash flows. These future business earnings are a function of business future performance, financially and operationally.

Business value is about the future earnings and risk

No matter how you slice it, you need to take a leap of faith and make some critical assumptions about how things will turn out.

Do errors of judgement occur? Yes, indeed. How useful your business appraisal is depends in large part on how well you can foresee the future for the company.

Devil in details – business valuation depends on your assumptions

Both the business appraiser and business clients reading the valuation report must take ownership of the process here. As a business person, you should read the entire report, not just the business value conclusion section. Otherwise, you may miss important assumptions that qualify the valuation result. The body of the appraisal report should tell you how these assumptions have led to the business value number at the end. Equally importantly, you can spot how sensitive the valuation result is to the key value drivers your business appraiser has considered.

In business valuation, the assumptions drive the results. If the assumptions are seen as reasonable by the intended readers of the report, the conclusion should come as no surprise.

If, on the other hand, you find the business valuation conclusion troubling, go back to the assumptions made at the outset. If still in doubt, ask your appraiser to clarify the assumptions or run what-if scenarios under alternative expectations to assess their effect on business value.

If you are working on a business appraisal, a big part of the analysis is reviewing the industry outlook. In many ways, the industry in which the business competes is far more important than the general economic situation. If you are valuing a strong company in a growing industry, its valuation is likely to be higher than that of a failing business that operates in a shrinking industry sector.

As part of your business valuation, you need to determine the overall industry growth potential, and the ability of your subject business to compete successfully. Some of the elements that should go into your analysis are the strength of the management team, the skill set of the key staff, financial condition of the firm, customer base, technology and other intellectual property assets, among other factors.

Your business appraisal report should outline clearly the industry sector and how the company fits into the competitive landscape. Business people and professionals reading your business valuation report should be able to gain a solid understanding of the risks faced by the company, its competitive advantages, and see how your conclusion flows from this thinking.

To make a compelling argument, you would need to provide a well researched description of the industry and the company’s plan on staying competitive. This is necessary in order to come up with realistic business valuation scenarios, such as the forecast of business earnings and assessment of the risks it is likely to face going forward.

Without this foundation, your valuation methods will merely generate unsupportable numbers. Remember the old adage, “Garbage in, garbage out.”

When it comes to business valuation, forecasting the business future financial performance is one of the most challenging, yet necessary tasks. Business value is about risk and returns going forward. Assessing how well you expect the business to do is at the core of establishing its value.

There are two ways to prepare the assumptions about the possible future financial performance of the company. One approach is for the business appraiser to come up with his or her best assessment. An alternative is to use the business management estimates.

Independent business valuations

If you expect the business appraisal to be subjected to serious scrutiny, objectivity of an independent business appraiser is key. This argues in favor of letting the appraiser do the forecasts of business earnings and expenses.

Rosy forecasts and overstated business value

Business management created financials are often rosy and based on aggressive goals. Many business people tend to underestimate the potential pitfalls that sharply limit the company’s ability to achieve such lofty objectives. This is especially the case when a company is facing serious headwinds currently, but hopes the coast will clear in the near future. More trouble ahead may well be overlooked.

The effect of these projections changes your business valuation result significantly. Take, for example, the discounted cash flow valuation method. The forecast of future earnings is a key input. If your cash flow forecast is unrealistic, especially in the early years, the value of the company will be overstated.

Unrealistic business valuation – uncomfortable questions

Valuations that are unexpectedly high are sure to generate skepticism from savvy business people and professional reviewers. An appraiser could state in the business valuation report that the assumptions of company’s management have been used in the analysis. The reader is put on notice, but is still left wondering why the business appraiser went with the management’s point of view.

Independent business earnings forecast – the objectivity advantage

If the business appraiser creates the earnings forecast from scratch, the readers of the business valuation report would likely expect a less enthusiastic but more sober set of assumptions. After all, business appraiser is not bound to endorse high expectations, but rather expected to provide a realistic measurement of what the business is worth.

Has the business appraiser covered all the angles?

The downside is that the business appraiser may not have the in-depth knowledge of the company to make the best projections. As an outsider, you may lack the understanding of the value drivers that can support the earnings growth the company’s management expects.

So what is the best approach? No clear answer exists. Perhaps close interaction between the experienced company management team and business appraiser is the best strategy.

When you face a dispute, whether partner disagreement or legal challenge, the parties are usually wide apart in their expectations of business value. To bridge the gap, keep in mind that a reasonable estimate of the future business outcome is usually achievable. If you expect to be challenged on your business valuation, be sure you or your business appraiser are as objective as possible and the key assumptions underlying your valuation are well supported by facts.

Business valuation controversy – when results are wide apart

Why so many disagreements? When trust between parties is lacking, they expect the opposite side to pressure their appraiser into producing the results they want. After all, they are paying for the business valuation. So suspicions abound: he who pays the piper calls the tune.

When in doubt, go to the key assumptions made in the business appraisal. Take a step back and ask the question, “Do you believe these assumptions?” If you don’t buy the assumptions, explore the alternatives that sound more realistic. See the difference it makes to the business valuation results.

Business valuation in divorce and other disputes

In a legal challenge, you are very likely to run across adversarial positions. The trust between the parties has been broken, and each side is pushing for its own point of view. Expect this to show up in the valuation results. Needless to say, this is immediately challenged by the opposing party.

Objective business valuations are best

Even in the most difficult situations, being objective in your business valuation is the best policy. The goal is to come up with the correct answer rather than push the envelope expecting to make a compromise down the road.

Hidden agendas like this only breed more distrust and endless arguments. Work to get it right the first time.

Sooner or later, this questions pops up for most business people. Whether you are selling or buying a business, hand the reins to a younger generation, seek investment to grow the company, or need to fend off legal challenges, the issue of business value comes up.

Most business people have no clue about business valuation

Now if you are like the typical business person, you are busy running the company. Measuring what it is worth is not the sort of thing you do regularly. The same holds true for most business professional advisors, including CPAs and lawyers. Business valuation is a specialized area that calls for know-how and attention to detail.

Just like with any business chore, cutting corners does not pay dividends. You can ask your business partners for advice, but odds are they know little. Opinions and anecdotal suggestions are no help, most are misleading and overly simplistic. The devil, as the saying goes, is in the details.

How to value a business – a high stakes game

Trouble is, business valuation is about as important a decision making point as it gets. Just consider the amounts of money at stake. Mishandling business valuation is likely to cost you thousands, result in a failed business transaction or a court judgment you will hate. Ask a seasoned business broker and your will hear an uncomfortable statistic: nine out of ten private business sales fall through because the buyer and the seller do not agree on the business value and its selling price.

Courts and tax man use business appraisals aggressively

It gets even more troublesome if you face a legal challenge or questions from the tax man. Courts have a way of enforcing their point of view and you may find a court appointed business appraiser does not agree with your idea of business value. Unfortunately, such business valuations are binding on all parties and professional business appraisers are trusted by courts and tax authorities.

Approach business valuation with respect

Whenever professionals are needed for a business task, you can surmise it is not easy. Indeed, business valuation has a lot of moving parts. For one thing, there are three fundamental ways to value a business. No one way, or approach to valuing a business, is definitive. Put another way, there are several ways to look at what a business is worth. Each approach offers a different perspective. Business appraisers are a detail oriented lot, leaving no stone unturned in their quest for measuring business value.

How to value a business? Three ways to do it

The three ways are formally known as the asset, income, and market approaches. Investing in a business requires capital to acquire business assets. The cost of creating a successful company is considerable. The asset approach seeks to reveal business value based on its operating assets and liabilities.

On the other hand, you can view any business as an income producing entity. Making money at an acceptable level of risk is the key objective and this is the view taken by the income approach to business valuation.

In the real world, businesses operate in a competitive environment. Similar companies can be compared to see what they are worth. Such comparisons are the cornerstone of the market approach.

If you take a look at a professional business valuation, all three approaches are used to figure out what a business is worth. In conclusion, business appraisers like to tie all their findings together in stating the business value. It could be an average of all the calculated values, or a range.

Troubled by business value result? Check the assumptions

One reason business valuations cost good money is that business appraisers are expected to study reams of business information in order to make careful assumptions and express their educated opinion at the end of the report provided to the clients. Such assumptions drive the conclusions of business value. If you have trouble buying the number, go back and review the assumptions.

What? Does the value of business goodwill change depending on the amount of current liabilities carried by the company?

It may not sound intuitive, but it actually is true. Consider the well known capitalized excess earnings business valuation method, the go to technique when valuing business goodwill.

A trick question: how much capital is committed to the business operations?

If you take a close look at how this method works, you will notice that the net asset value is calculated as the difference between the adjusted business assets less its current liabilities. This net asset value is then multiplied by the fair rate of return to estimate the capital charge, or the amount due on the committed business capital. The greater the net asset value, the higher the capital charge.

Excess earnings – what’s left after return on committed capital

Now for the fun part. The capital charge is next subtracted from the business earnings basis in order to calculate the excess earnings. This quantity gives the method its name. The idea is that a well run business generates earnings in excess of the capital charge thus providing superior return on investment.

Higher excess earnings indicate higher business goodwill

The capitalized excess earnings method determines the value of business goodwill by capitalizing these excess earnings. So the higher the excess earnings, the greater the business goodwill value. Businesses that put more money into the owners’ pockets are associated with higher business goodwill.

Notice that the capital charge is affected by both the total business asset values as well as the current liabilities. Given the asset values, higher current liabilities result in a lower net asset value and smaller capital charge. This in turn leads to higher excess earnings and increases the amount of business goodwill.

That’s how the capitalized excess earnings valuation method works. But what does it tell you in pure economic terms?

Higher earnings with less capital required often result in higher business goodwill

It essentially implies that those businesses able to operate on lower net asset bases have higher goodwill. These companies use Other People’s Money very effectively to finance their operations, usually in the form of short term borrowing from their suppliers.

The secret behind e-commerce success – lower working capital requirements

An example would be an e-commerce online retailer that gets paid shortly after selling the products. At the same time, the company enjoys attractive short term financing terms from its vendors. In addition, it reduces the need for working capital by managing its inventory just in time. The result is lower inventory shrinkage, more economic reordering strategy, and less capital tied up to meet the sales goals.

This is one reason online businesses are often able to out-compete their brick-and-mortar competitors. The online companies do not require expensive real estate for merchandizing and can manage their inventory and other direct selling costs more flexibly. Online businesses tend to focus on efficient and cost effective order fulfillment without the extra overhead of a retail store presence in a high priced shopping mall.

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.