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 [email protected].