What's a Business Worth? Valuation Methods for Accountants
Accountants are sometimes asked to value a business because of a buy-back agreement, merger or acquisition, tax matter, admission or withdrawal of a partner, litigation between the parties, attempt to expand the credit line, etc. What would a prospective buyer be willing to pay for the business? It is quite difficult to value a closely-held concern because each company has its own unique characteristics. Often, consideration has to be given to the future profits the company will be able to earn. The valuation may be influenced by the reason for it. For example, a different approach may be appropriate for divorce litigation compared to the price to pay for a targeted company compared to valuation for estate tax purposes. Thus, valuation depends on the purpose at hand. The valuation process is an art and not a science, since everyone's perception is slightly different. In litigation matters, the valuation method selected should be logically consistent, reasonable, cost-effective and simply explained.
As a beginning step in valuation, the key financial data must be accumulated and analyzed including historical financial statements, forecasted financial statements, tax returns, industry information, competition, economic statistics, political measures, etc. The accountant must be thoroughly familiar with the nature of the business. Also, the assumptions of the valuation must be clearly spelled out.
In valuing a business, you must take into account the customer base, track record of profits, reputation, maturity of business, ease of transferability of ownership, growth potential, lease terms, type and stability of business operations, risk level, economic and political environment, nature of the industry, degree of competition, management ability, marketing factors and liquidity.
When valuing a business, it is suggested that the company be compared to competing companies in the industry. Also, industry norms may be used as benchmarks. Industry information may be obtained from various sources including trade magazines and newsletters, financial advisory service reports (e.g., Dun and Bradstreet), books (e.g. L. Troy's Almanac of Business and Industrial Financial Ratios published by Prentice-Hall), and professional organizations' studies (e.g., Robert Morris Associates' Annual Statement Studies).
There are many available valuation methods. The "right" method has to be used in the particular circumstances. However, what is the right method? Often, alternative methods are employed and the findings compared. An average valuation based on a few methods may be used.
You must carefully document your work, especially when you will serve as an expert witness. The value of a business may be based on a net assets (assets less liabilities) approach and/or a profitability approach. In using assets as a valuation base, the fair market value of the net tangible assets is typically determined by independent appraisal. To this, add the computed value of intangibles (e.g., goodwill). When earnings are used as a base, net income is adjusted for reconciling items and then multiplied by an appropriate capitalization rate. Depending on the profitability approach used, we can use historical or projected accrual earnings or cash earnings. The accountant should use a variety of methods to establish a specific value or range of values for the business. Reference may be made to rules of thumb" formulas for the particular industry that can be found in trade publications and financial advisory services. There are even published books providing this information. An example is Glenn Desmond and john Marcello's Handbook of Small Business Valuation Formulas (California: Valuation Press, 1988).
Most importantly, the valuation has to be realistic. If you undervalue the business, the owner will not get what it's worth upon sale. If you overvalue the business, the owner's price may be too high and, thus, he or she will not be able to sell it. …