Is a business valuation needed when you aren’t planning to sell your business? What factors determine a company’s value? What do you need to know before hiring a valuation professional? These are some of the common questions that business owners pose when the issue of a valuation is raised. Since 2011 is expected by some economists to see an increase in mergers and acquisitions activity, it is a good time to review the role of business valuations.
“Valuations are useful in such circumstances as mergers and acquisitions, due diligence by a lender, succession planning, estate planning and complying with government regulations,” says Jeff Hipshman, partner, HMWC CPAs & Business Advisors in Tustin. “Even if none of these trigger events are happening now, it still can be beneficial to have a valuation. A business valuation can impart insights into a company’s strengths and weaknesses, as well as provide a road map for increasing its value. Understanding what adds value to your company can help you in future business decisions, such as timing the sale of your business for the maximum selling price.”
Smart Business spoke with Hipshman about some of the typical questions that business owners ask about business valuations.
Why is a valuation needed?
Valuations can be helpful in many situations, including some you may not have even thought about:
- You want to buy or sell a business.
- You are divorcing.
- You use gifts as a tax strategy in your estate plan.
- You are liquidating your business.
- You are the executor of an estate.
- You are setting up a buy-sell agreement.
- You are seeking business financing.
- You are doing strategic planning.
- You require a fairness opinion.
- You need to comply with certain FASB standards.
- You are converting your C corporation to an S corporation.
What methods do valuators commonly use?
The business is first analyzed and then a valuation method is selected based on the analysis, the interest being valued and the purpose of the valuation. Your financial statements are a starting point when setting a value for your company. But important information will be missed if the analysis relies solely on the financial statements. Valuators select their valuation methods based on their analysis and all other facts and circumstances.
Typically, a valuator considers one primary method to derive the asset’s value, and one or two others to serve as checks or supports of that value. The process of valuing a business is necessarily somewhat subjective. Valuation professionals may vary in their estimates. In using the various methods, even the same valuator may come up with several estimates.
Here are some of the most common valuation methods:
- Income approach. This approach capitalizes the company’s expected income or cash flow stream by determining the rate of return on investment required by a potential investor, and it sets the value at the amount appropriate to generate that rate of return. This method is often used in conjunction with a discounted cash flow analysis to estimate the present value of the future stream of net cash flows generated by the business.
- Market approach. This approach gathers data from acquisitions of similar businesses or from the stock prices of comparable publicly traded companies. The valuator adjusts the data to account for differences between the subject company and comparable firms. An adequate number of comparable companies are necessary to produce credible results.
- Asset-based approach, also called adjusted book value method. This approach requires establishing the value of all assets and liabilities as a method of valuing the entire business. This method is often used when a business’s earnings and cash flow don’t materially contribute to its value. The identification and valuation of intangible assets is the most challenging aspect of this method.
To ensure a quality valuation, be sure to hire an independent valuator who knows the ins and outs of your company and industry.
What makes some businesses worth more than others?
Many factors affect your company’s value. In addition to financial factors (e.g., profitability, revenue sources, cash flow, current debt and equity), some of the key factors affecting value include:
- Economy: Economic conditions, especially costs of materials and availability of capital, can profoundly affect a company’s continued profitability.
- Industry: A particular industry’s economic outlook can have an impact on the value of a business. In addition, markets and channels of distribution as well as changes in production technology can greatly affect a company’s future potential and have a major impact on value.
- Competition: The number and nature of current and potential competitors and their ease of entry into a company’s market can profoundly affect a company’s success.
- Regulations: From a valuation standpoint, compliance requirements and restrictions to market entry may be particularly important. Also, current or anticipated zoning and licensing restrictions can substantially affect price.
- Market position: Reputation, pricing policies and diversification of customer base all significantly affect a company’s ability to generate earnings.
- Intangibles: An established name and reputation, a customer base, a skilled work force and many others are what increase the value of a business above its tangible assets’ fair market value. They can greatly increase a company’s profitability.
- Internal controls. The functioning of accounting and operational controls affects risk. If internal controls are faulty, financial and other data could be as well.
Jeff Hipshman is a partner at HMWC CPAs & Business Advisors (www.hmwccpa.com), one of Orange County’s largest local accounting firms. Contact him at (714) 505-9000 to discuss how your company or client could benefit from HMWC’s business valuation services.