Best business valuation formula for your business

Assets and earnings valuation often used for gift tax valuation

Assets and earnings valuation, known as the excess earnings method, takes both assets and historical earnings into consideration in arriving at the value of the business. This is the method prescribed by the IRS for estate and gift tax situations when there's no other more appropriate method. It can also be used in appraising a business that's being put up for sale, although the IRS does not prescribe it for this situation.

Since the IRS has sanctioned this method for at least some purposes, your appraiser may want to use it also, particularly if you're concerned about IRS scrutiny of your tax returns reporting the sale. You may sometimes see this method referred to as ARM 34, which is what the IRS calls it.

To use this method, you must first recast your historical financials to show how the business would have looked without the owner's excess salary and perks (that is, the amount over and above what a non-owner manager would have been paid), non-operating or nonrecurring income/expenses, etc.

For the income statement, a judgment call must be made as to whether you should look only at the last year's statement, or at some combination of statement results from the last three to five years (the most common combinations are a simple average, a weighted average that values the most recent years more heavily, or a trend line that factors in the percentage and direction of growth each year). The IRS prefers to see figures that represent a five-year average, which seems to be a reasonable approach.

For the balance sheet, use the most recent month's sheet, recast to reflect current market value. The starting point for the value of your business is the net value of your assets as shown on the recast balance sheet. But how much more should you get, based on the business's goodwill or intangible value?

Putting a price tag on goodwill. From your recast financials you can determine your historical annual earnings figure (generally, EBIT or earnings before interest and taxes). From this you'll subtract the portion of earnings that's attributable to your assets alone. Anything left over is the "excess earnings" — the portion that's attributable to the going-concern value of the business.

How do you determine the portion of earnings that are attributable to your assets? One way of looking at this is, if the assets were sold and the money invested at market rates, how much could you get? How much is the market paying for other investments of similar risks? This is one of many areas where the expertise of a professional business appraiser can be invaluable.

For example, your appraiser might say that, in view of the risk involved in your particular business, your annual return from the current assets should be about 150 percent of the rate of a short-term government bond; your annual return from the long-term assets should be about 188 percent of the bond rate.

After you compute the expected returns from your assets, compare the total with your historical earnings figure. If the historical earnings figure is higher than the return from assets, the difference is called "excess earnings." The excess earnings can be divided by a capitalization ("cap") rate to arrive at their value. Although a professional appraiser will spend a good deal of time and effort determining the proper cap rate to use, in today's market it will generally be somewhere around 20 to 25 percent, or enough to recover your investment in four to five years.

Example

Your recast balance sheet shows a net current asset value of $80,000, and a net long-term asset value of $200,000. So, the minimum or base price for your business should be $280,000 — the market value of your assets.

Now let's assume that your historical annual earnings figure is $150,000. How much of this earnings figure is attributable to the assets? You might calculate that under current market conditions the return on current assets should be $80,000 x 7.5% or $6,000, and your return on long-term assets should be $200,000 x 9.4% or $18,800.

Thus, your total earnings attributable to your assets is $6,000 + $18,800 or $24,800. Subtracting this "asset return" figure from your total earnings, you arrive at an excess earnings amount of $125,200 ($150,000 - $24,800 = $125,200).

Using a cap. rate of 20 percent, the value of your excess earnings is $626,000. Add to this the current market value of your assets, and you arrive at a total price of $906,000 for the business ($626,000 + $280,000 = $906,000).

Larger companies often use future earnings valuation

Theoretically, anyone purchasing a small business is interested only in the business's future. Therefore, a valuation based on the company's expected earnings, discounted back to arrive at their net present value (NPV), should come the closest to answering the buyer's questions about how much the business is really worth today.

That's the theory. However, in practice, valuations based on future performance of the company are the most difficult to do because they require the appraiser to make numerous estimates and projections about what's around the bend. They are also the most time-consuming methods. If inexpertly done, future earnings methods can result in a target sales price that's way off base.

Nevertheless, if you think that your most likely buyer is a larger company, it may be worth while to have your appraiser use one of these methods. If carefully done by an expert business appraiser, valuation methods based on future earnings can result in setting the highest reasonable price for your business.

Methods based on future earnings are very frequently used by larger companies in either merger or acquisition situations. The large-company acquisitions manager will understand the method behind the madness of making so many predictions about the future. Moreover, large companies are often "strategic buyers" who are likely to accept a higher price for your company in any event, provided that you can justify it. That being the case, why not set the highest asking price that you can reasonably back up with some mathematical formulas and pro forma (projected) statements?

Using the discounted cash flow method. How do you go about setting a price based on future earnings? The first step is to look at your recast financial statements. Working from these, your appraiser will create projected statements that extend for five or more years into the future. Each year's free cash flow will be determined (some appraisers prefer to look at each year's earnings before interest and taxes or EBIT). These projections should not assume any major changes by the new owner, since you are trying to measure the company as it exists today; the new owner doesn't want to pay you for the value he or she hopes to add to the company!

Once you have done this, the projected free cash flow from each year is discounted back to the present, to arrive at the net present value of each year's cash flow. These NPVs are added up, to arrive at the total NPV of the company's earnings for the near future.

Tools to use

How do you compute NPV? The easiest way is to use a good financial calculator. If you don't have one, or don't want to take the time to learn how to use one, our Business Tools contains a simple "present value of $1" table that you can use to compute the NPV of your cash flows.

The key here is deciding which discount rate to use. The higher the rate, the lower the answer you'll get as to the value of the company. The discount rate must reflect the appraiser's best guess as to what the market rate will be for investments of a similar nature over the next five years. It should also factor in the buyer's expected cost of capital (i.e., the interest rate on an acquisition loan) and the expected inflation rate. Choosing the correct cap rate is perhaps the most difficult task the appraiser must do — and perhaps the most mysterious to the rest of us. Let's just say that expertise in this area is one of the main things you're paying your appraiser for.

The next step in using the discounted cash flows method is to determine the residual value that the company will have after the five (or more) years of your projected statements. There are a number of different ways of doing this, more or less precisely.

One of the easier methods is to take the estimated cash flow from the last year you've forecasted, and assume that level of cash flow will continue indefinitely into the future. Obviously, this is a rather conservative prediction because most buyers will want the company to continue to grow after the next five years! But, at any rate, you can take the last projected year's free cash flow, divide it by the discount rate, and arrive at the company's perpetuity earnings value. This value becomes the company's residual value, which can in turn be discounted to find its NPV.

Finally, the NPV of cash flow from each of the projection years, plus the NPV of the company's residual value after these years, is added up to arrive at the present value of the business.

Example

Let's say that after doing your best to look into the future and forecast the next five year's cash flow, you arrive at the figures in column one. Assuming a 20 percent discount rate, you come up with the following figures:

Merger specialists favor market-based valuation methods

Several business valuation methods are based primarily on the market price for similar businesses at a given point in time. Business brokers and mergers and acquisition specialists are more likely to favor these methods, at least as benchmarks, since they have access to data about recent sales and merger activity. Ideally, market-based methods should be used in conjunction with an examination of earnings (historical or projected) so that they can serve as a "reality check."

Comparable sales method. The comparable sales method attempts to locate similar businesses that have recently sold in your area, and uses those comparable sales figures to set a price for your business, adjusting appropriately for differences. While widely used for real estate sales, this method is difficult to apply to business valuations because of the problems in gathering information about small business sales and because of the unique character of each business.

Rules of thumb/industry averages. These are frequently used by business brokers, based on their experience and on published standards for their industry. For example, your broker may tell you that lately your type of business has been selling for about four times the gross monthly revenues.

However, a rule of thumb does not take into account any of the factors that make your business unique, and using one can result in setting a price for your business that's way too high or too low. Nevertheless, small businesses are often sold at a price based on rule of thumb, simply because it's a relatively fast, cheap method to use, and because it will result in a price that seems reasonable to buyers who have been looking around at a lot of similar businesses.

P/E ratios. The profit and earnings ratios of publicly owned companies in your industry are widely available, and can often be used to set and compare prices for large companies with liquid stock. However, that's the point: these companies' stock is easily bought and sold, and it's easy for any investor to buy publicly-traded stock in many different companies.

Consequently, large-company stock commands a premium (perhaps 35 to 70 percent) because it is much less risky than an ownership interest in a small, closely held company. Also, remember that purchasing a small business will usually tie up all the buyer's funds and prevent him from diversifying his risk, which further contributes to relatively low prices for small business interests. For these reasons it's best not to compare the value of your small company with the P/E ratio of a large one, at all.

Valuing partial interests in business

Our discussion of business valuation methods assumes that you're attempting to put a value on the entire business in anticipation of sale. But what if you want to sell off just a part of the business? Or, what if you want to give away part, as part of your long-term succession plan?

Minority interest discounts. In family companies, it's fairly common to have a controlling interest in the company held by the founder, with smaller blocks of stock held by the children or key employees. If the entire company will be sold, state laws protect those holding minority interests and typically require that they will receive their pro rata share of the sales price. Thus, if the company was valued at $1,500,000, a 10 percent shareholder should receive $150,000 if the entire company were sold.

However, if only part of the company is currently being sold or given away, minority interests are valued at a discount from their pro rata price. The reason is simply that a minority owner is not likely to have much influence on the way the company is run. He can't control the board of directors, control the payment of dividends, or even prevent himself from being fired if he's an employee.

Exceptions could occur if no one held a majority interest in the company, or if the company bylaws specified that a super majority vote (e.g., two-thirds) were required to take certain actions. But, in most situations, the lack of control means that the value of a minority interest on the open market is considerably less than the value of the entire company would suggest.

The IRS recognizes this and will allow a "minority discount" on the price of the stock. Typical discounts range from 20 to 40 percent, although greater discounts might be possible depending on the facts of the situation. In the usual situation, the discount is good news because it allows the business owner to give away part of the company while minimizing gift taxes, or to sell part of the company while minimizing capital gains taxes and allowing the purchaser to buy into the business at a reasonable cost.

Since tax consequences are so important whenever business interests are transferred, and since the IRS tends to examine minority interest values very closely because of the opportunity for abuse, we strongly suggest that you use the IRS's rules in deciding the discounted price.

Majority interest premiums. If a minority interest gets a discount, then you might logically think that a premium should apply to a majority interest because the interest effectively controls the corporation. If you thought that, you'd be right. Majority interests, when sold or given away, are typically valued at more than their pro rata share of the company's value.

For example, a majority interest of 75 percent of the stock might actually be worth 90 percent of the total value of the company. A majority interest should never be worth more than the total company value, however, since those holding minority interests would always be entitled to something upon sale or liquidation of the company.

If you're planning to pass your business on to the next generation of your family, carving out minority interests and giving or selling them to your successors can be a good way to reduce your estate or capital gains taxes.