Business Valuation

If you are the owner of a business, the question that comes to mind is, “What is my business worth? What can I get for it?”. To answer that question, I suggest we step back and ask ourselves what any investment is worth. This is important because the answer is the same whether you are investing in certificates of deposit, real estate, publicly traded stock, or a closely held business. What you are willing to pay for an investment is the present value of the expected future cash flows. This is true whether the future cash flows are interest, or rents, or dividends, plus the cash from the ultimate disposition of the asset (investment). This may seem too simplistic, but it is the case. The difficulty comes, of course, in trying to project, estimate, and discount those future cash flows.

The good news is that there are standards and methods for arriving at these numbers and values. This may surprise you, but historically the conceptual leader in business valuation theory has been the Internal Revenue Service (IRS). The IRS first issued related rulings in 1934. The most significant ruling was number 59-60. If you are involved with business valuations in any regard, I would recommend that you get a copy of and read that Revenue Ruling. There are other organizations that are heavily involved in the art/science of business valuations. Fewer than a half dozen of such organizations issue standards and certify persons’ knowledge and skills in this area. I am so certified and a member of two such organizations, and am familiar with the standards of most of them. The standards are all demanding, rigorous, and similar from one organization to another. There is, of course, a good deal of subjectivity, but the process is neither a guessing game nor something that comes to you in a dream.

Let’s remember that “cash is king”. The value of any investment is the present value of the anticipated future cash flows. Here are some methods that are useful for estimating that value. If you are lucky, there is an existing market (like the stock market) for your company’s stock or companies very much like yours. There are also methods that concentrate on dividend history and abilities, and price/earning ratios of comparable companies. In the absence of such comparable data and information, one can estimate, project, forecast the timing of, and discount future cash flows. That can be very tough for large or closely held companies. It is hard to project into next year or even the next after that, let alone for five or more years. Consequently, valuations of closely held companies often turn on historic earnings.

Let me comment on “rules of thumb”. Rules of thumb are just that. They are, at best, reality or sanity checks. Usually they have some bias in history and/or fact, but they are generalizations. Every situation is unique and different, so you can not go charging ahead based on a rule of thumb. One thing that is certain in life is change. So the older the rule of thumb, the less likely that it is applicable today. The business world is also different geographically. What is so in Germany may not be so in the USA. Good heavens, what is so in New Hampshire may not be so in Arizona. Just be very cautious about the use of rules of thumb.

Again, the valuations of closely held companies often turn on historic earnings. By this I mean that the historic earnings are a starting point for the process. The earnings are then “normalized” or converted to “economic” earnings. An average income is then determined with or without a weighting of the average. To this average, a multiple is applied. Many people like to apply rules of thumb in determining a multiple. But that can be especially troublesome. The multiple is a function of the risk associated with the particular industry and business relative to risk free investments. The risk, and therefore the multiple, must be carefully assessed and calculated. After applying the multiple a number of discounts and/or premiums are applied. These are often a function of the percent of ownership being valued and the relative ease with which the owners could convert the business’s assets to cash. The greater the difficulty of converting the assets to cash, the greater the discounting of the value.

After all of this, you have a number from which you can negotiate with the other party, the buyer or the seller. I would be the first to admit that things can get really wild at this point especially if it is merger mania time.