Whether you’re selling your business or doing estate and gift tax planning, you may need to know what your company is worth. Business valuations take into consideration the economic and industry outlook, the investing public’s confidence, your financial performance, assets and market value, and more.
“There is not one universal formula used to value a company,” says Elaine Rockwell, CPA/ABV, CVA, associate director in the business valuation and litigation consulting services group at SS&G Financial Services, Inc.
There are guidelines that should be considered, however. The same ruling that valuation practitioners relied on 50 years ago still applies today: Revenue Ruling 59-60. By considering eight factors, you can understand the risks, opportunities and market conditions in determining a value estimate.
Smart Business spoke with Rockwell about business valuations and how the pieces all come together.
Are all companies valued the same way?
Companies are different, so valuations are different. There are three general approaches to value a business: the asset, income and market approach. The asset approach is generally based on this equation: assets - liabilities = value. The value of assets, such as property, plant and equipment, may need to be adjusted to reflect current fair market value. This approach is commonly used in asset-intensive businesses, small businesses and professional practices where there is little or no goodwill. An asset approach does not consider goodwill and other intangible values, therefore, it is less appropriate when valuing an operating company.
The income approach mainly depends on the present value of future cash flow, often based on historical financial statements adjusted for the nonrecurring, non-operating, and non-market value of income and expenses. The issues to consider are how much income/cash flow your company generates and whether your expenses are reasonable and comparable to the industry.
The market approach compares your company to a similar publicly traded company. This method is generally more appropriate for larger businesses. Finding a ‘match’ is critical for generating an accurate valuation.
What is needed to prepare for a valuation?
Valuators generally want to review five years of historical financial statements and tax returns. They’ll look at whether there are stockholder agreements in place or buy-sell agreements, leases or loans, among other information. You’ll produce a lot of records during the valuation process, and you’ll answer questions about your operation, competition, industry and history. That is where Revenue Ruling 59-60 comes in.
What are the eight factors?
- Nature and history of the company: What products and services are generated, and how has this changed over time? What are the assets, both operating and investment, capital structure, management, etc.?
- Economic outlook: How are your competitors performing, and what is your ability to compete given the current and prospective economic and industry conditions?
- Book value of stock and financial condition: This refers to the balance sheet and income statements. How much debt do you have? What is your capital structure?
- Earning capacity: How much net income is available for dividends? What percentage of income is reinvested in the company? Earning capacity is a prediction of the future.
- Dividend paying capacity: This looks at what dividends could be paid. This factor is less important when valuing the controlling interest of the company because the ‘controller’ can decide what the dividends will be.
- Goodwill of the company: An intangible asset resulting from name, reputation, customer loyalty, etc. It’s generally based on the excess of net earnings over and above a fair return on the net tangible assets.
- Sales of company stock: Transfers between unrelated shareholders are generally good indications of value. This precludes transactions between a father/owner selling stock to his son at less than fair market value, which is not at arm’s length.
- Market approach: The IRS considers this the best method of valuing a company because it shows what the investing public thinks the company is worth based on actively traded stock. However, this is usually the most difficult approach since all businesses can’t be compared to publicly traded companies because of size, multiple divisions, international operations and other reasons.
Is there an ‘expiration date’ on valuations?
There are many factors that play into valuations, with the key indicators being economic and industry conditions and the investing public’s confidence, which are constantly changing. Economic and industry conditions, such as changing interest rates, inflation, unemployment, the market and competition, can have a dramatic effect on value. For this reason, a valuation performed several years ago is most likely not accurate today. If a valuation is prepared for estate and gift tax purposes, the IRS may consider any valuation older than six months to be stale. Although Revenue Ruling 59-60 is still the foundation of business valuations, it is important that your valuator also considers rapidly changing case law, IRS Statements of Position, valuation standards, evolving techniques and tax ramifications. Read your valuation to make sure what’s important to you is adequately addressed. If you were parting with your own money, would you be interested in buying the company?
ELAINE ROCKWELL, CPA/ABV, CVA, is an associate director in the business valuation and litigation consulting services group at SS&G Financial Services, Inc. Reach her at (440) 248-8787 or ERockwell@SSandG.com.