Business Valuation Methods

Gregory J. Cook, EA, CPA+ Accredited Tax Advisor Past President Alabama Society of Enrolled Agents Past President Alabama Association of Accountants

The key to a supportable "Business Valuation" is to use methods and procedures that are accepted and used in the valuation industry.




Owner Benefit Valuation

This formula focuses on the seller's discretionary cash flow and is used most often for valuing businesses whose value comes from their ability to generate cash flow and profit. It uses a fairly simple formula -- you multiply the owner benefit times 2.2727 to get the market value. The multiplier takes into account standard figures such as a 10% return on investment, a living wage equal to 30% of owner benefit, and debt service of 25%.
Asset Valuation

Asset valuation is used when a company is asset-intensive. Retail businesses and manufacturing companies fall into this category. This process takes into account the following figures, the sum of which determines the market value:

Fair market value of fixed assets and equipment (FMV/FA) - This is the price you would pay on the open market to purchase the assets or equipment.
Leasehold improvements (LI) - These are the changes to the physical property that would be considered part of the property if you were to sell it or not renew a lease.
Owner benefit (OB) - This is the seller's discretionary cash for one year; you can get this from the adjusted income statement.
Inventory (I) - Wholesale value of inventory, including raw materials, work-in-progress, and finished goods or products.
Capitalization of Income Valuation

This method places no value on fixed assets such as equipment, and takes into account a greater number of intangibles. This valuation method is best used for non-asset intensive businesses like service companies.

In his book "The Complete Guide to Buying a Business" (Amacom, 1994), Richard Snowden cites a dozen areas that should be considered when using Capitalization of Income Valuation. He recommends giving each factor a rating of 0-5, with 5 being the most positive score. The average of these factors will be the "capitalization rate" which is multiplied by the buyer's discretionary cash to determine the market value of the business. The factors are:

Owner's reason for selling
Length of time the company has been in business
Length of time current owner has owned the business
Degree of risk
Profitability
Location
Growth history
Competition
Entry barriers
Future potential for the industry
Customer base
Technology


Again, add up the total ratings, and divide by 12 to come up with an average value to use as the capitalization rate. You next have to come up with a figure for "buyer's discretionary cash" which is 75% of owner benefit (seller's discretionary cash for one year as stated on the income statement). You multiply the two figures to determine the market value.
Multiplier or Market Valuation

This approach finds the value of a business by using an "industry average" sales figure as a multiplier. This industry average number is based on what comparable businesses have sold for recently. As a result, an industry-specific formula is devised, usually based on a multiple of gross sales. This is where some people have trouble with these formulas, because they often don't focus on bottom line profits or cash flow. Plus, they don't take into account how different two businesses in the same industry can be.

Here are a few industry multiplier examples:

Travel agencies - .05 to .1 X annual gross sales
Ad agencies - .75 X annual gross sales
Retail businesses - .75 to 1.5 X annual net profit + inventory + equipment