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There are three approaches generally used to determining the value of any business:
COST OR ASSET APPROACH
The cost of something does not necessarily determine its selling price. This is true in a rapidly changing market which is highly affected by technological changes or variances in supply and demand. This is especially true if a company is very young and has not yet established enough of a track record to make a confident analysis of future performance.
Book value is a figure that different businesses have arrived at some or less common set of rules within the scope of generally accepted accounting principles. Each asset or liability number that is a component of book value as shown in the financial statements represents a specific set of obligations that can be identified detail by referring to the company records, assuming the bookkeeping is complete and accurate.
Book value provides the most convenient starting point for an asset value approach to the valuation of a business interest
The nature and extent of adjustments that should be made to book value for the business valuation depend on many factors. One is the purpose of the valuation, and another is the availability of reliable data.
The cost approach is used when the income stream generated by the business does not adequately reflect the value of the company
The market approach to valuing a closely held non-traded company involves comparing the subject company to counter parts engaged in the same or similar lines of business. However, similarity in size, methods of operation, markets and customers served projected growth in sales and earnings are important for reliable market approach results. Since the IRS and USPAP appear to prefer the Market approach to value determination, it is the method of choice for the firm Daniel Cullinane CPA.
The market approach is based n third party verifiable transactions. Successful usage of this approach requires that the analyst have access to a large data base of arms length transactions involving companies similar to the subject company. Information on sales of comparable companies can be difficult to obtain for someone not privy to the transactions. When such data is publicly available, the market approach is the most credible and understandable of the three.
Multiples of earnings are usually the best way to measure the value fo a particular business Businesses exist to provide earnings to their owners, shareholder or members. The only truely neutral measure of earnings is Seller Discretionary Earnings because it is the only measure of earnings that removes the discretionary treament of taxes, interest,depreciation, owners salary,health benefits, and other nonsalary perks This is the true earnings available to the owner,
Daniel Cullinane CPA analyzes valuation using both multiples of revenue and earnings.
CORRELATION OF METHODS
It is important to note that under guidelines set by The Uniform Standards of Professional Practice, the Internal Revenue Service ruling 59-60, as well as most valuation societies. The evaluator is required to use all approaches for which reliable data is available and applicable. The use of as many approaches and methods within these approaches is useful to the extent it will establish a range of values for the entity being appraised.
Revenue Ruling 59-60 recognizes the fact that appraising is not an exact science. Sound valuation will be based upon relevant facts, but the element of common sense, informed judgement and reasonableness must enter into the process of weighing those facts and determining their aggregate significance
The asset value approach is used to determine a minimum value range for a business. This amount represents the estimated market value of all tangible assets. This method does not include the value of sellable inventory.
Asset value must not be determined on the basis of book value or an asset's worth in its current application but must consider replacement value, including all installation and testing costs. The upper and lower asset values are determined based on the accuracy of the asset data that was provided by the client.
COMPARISON FACTORS METHOD
This method takes into account the critical factors which encourage or discourage the potential buyer in investigating and or purchasing this business Internal formulas are used to compare subject company to other companies in the same industry.
This factor weighs the possibly of market saturation, volatility of the industry, predicted survival for an established business and the future stability of profits
This fact quantifies the buyer's motivation to buy on status, visual appeal, profitability risk and skills required.
This factor places value on the size and consistency of the client customer base.
This factor places value on the company's system and processes that are in place to generate income and control expenses.
This method of valuation is purely a financial model. Expenses are deducted from revenues to determine cash flow Deductions are then made for the owner's salary and depreciation. The result is discretionary cash for debt service.
The maximum debt service this business could given the current level of discretionary cash is calculated based on the assumption of the number of years financed and an interest rate.
This method is based on pricing formulas and rules of thumb that have been established for a specific industry . Most of the rules of thumb are based on multiples of revenues or earnings.
COMPARABLE SALES METHOD
This method is based on comparing the business being valued with similar businesses that have been sold. Since revenue numbers are usually more accurate than net income numbers, I calculate a weighted intangible price to revenue ratios based on previous business sales and then calculate an intangible value to which I add back the company's assets to arrive at a total value.
MULTIPLE AVERAGED VALUE METHOD
This method is the average of all of the previously described formulas based on the theory that a diligent buyer would rely on more that one of the formulas. An average of all the formulas should represent the actions of a reasonable buy
APPROACH TO VALUATIONS
A business valuation is an opinion of the value of the business based on our experience, training and integrity. In reaching a conclusion, comparison of businesses usually involves adjustments due to the individuality and uniqueness of each business.
Being an opinion of value, the business valuation cannot be guaranteed, nor can it be proven. The valuation can, however be substantiated and the final opinion is the result of a thorough professional analysis of a large amount of data, the valuation must not be considered absolute but should be used as a basis of negotiations between concerned parties
Our valuation methodology will be in compliance with IRS Revenue Ruling 59-60. The purpose of the revenue ruling is to outline the general approach methods and the factors to be considered in valuing shares of the capital stock of a closely held corporation.
The regulations define fair market value as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
A determination of fair market value, being a question of fact will depend upon the circumstances of each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues.
The fair market value of a stock will vary as general economic conditions change from normal, to boom or depression. Valuation of securities is, in essence, a prophesy as to the future and must be base on facts available the day of the appraisal.
Per the Internal Revenue Service the following summarizes the key factors to consider:
Balance Sheets will be obtained for two or more years. Income Statements for five years if available. These statements will be analyzed to assist in the valuation process.
FAIR MARKET VALUE
The single most important factor to influence the value of a business is the supply and demand of a equally desirable substitute that is available in the market place. According to the principle of substitution, the value of a business tends to be determined by the cost of acquiring an equally desirable substitute. A buyer will pay no more for a business than the cost of acquiring a similar business. This concept is the basis of fair market value and is the overriding methodology we use.
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Daniel Cullinane CPA
25 Plaza 5 25th fl Jersey City NJ phone 732-516-1648 fax 732-516-9778
2500 Plaza 5 25th fl Jersey City NJ 07311 phone 732-516-1648 fax 732-516-9778