Breaking down various valuation methods
When looking to sell a business there are different ways to value that business in order to offer a competitive rate.
Book Value: This is the simplest method. The book value of a company is the assets minus the liabilities. Sometimes this method is also known as the net worth or owner’s equity valuation method. The problem with the book value is that the valuation fails to take things like goodwill, intellectual property, continuing business, and the value of the business relationships and contracts into account. The plus side of this method is that it does take into account the value of the business’ assets which some valuation methods neglect.
The Breakdown:
Assets – liabilities = Book value
Example: $1,000,000 – $500,000 = $500,000 Book Value
Capitalization of Earning or Future Value of Earnings Method: This method takes into account for the future value of the company. In this method, the business will need to determine the earnings, which is the accounting net profit plus the owner’s excess salary plus depreciation expense and discretionary expense items. The owner’s excess salary would be the amount the owner gets paid over and above what a manager would get paid for doing the same job. Once the earnings are determined then that number will need to be divided by the capitalization rate. Large businesses with good financials, stable earnings, and well-developed management will have the lowest capitalization rate with around 10 to 15 percent. Medium to large businesses that are well-established with good top management will have a rate of around 15 to 20 percent while smaller, less-stable businesses would have a higher rate. The problem with this valuation method is it does not consider the value of the assets and assumes future earnings will be consistent with current earnings. It also fails to consider the time value of money and discount the value of current rates.
The Breakdown:
1. Accounting net profit + owner’s excess salary + depreciation + discretionary = Earnings
2. Rate of return for investor = capitalization rate
3. Earnings / capitalization rate = Capitalization of Earnings
Example: $500,000 + $50,000 + $-25,000 + $-15,000 = $540,000 Earnings
Rate of return: 20 percent
$540,000/.2 = $2,700,000 Capitalization of Earnings
However, there is a slight tweak to this method that some buyers use. Some buyers require future earnings be discounted to the current value along with the capitalization rate. This means a business would need to first look at the capitalization rate and then use that rate in a present value interest table.
The Breakdown:
Capitalization rate: 15 percent
Year one: .85
Year two: .60
Year three: .45
Year four: .30
Year five: .15
Earnings first year: $1,000,000
Earnings divided by year one rate (repeat for all five years):
Year one: $1,000,000 / .85 = 850,000
Year two: $1,000,000 / .60 = 600,000
Year three: $1,000,000 / .45 = $450,000
Year four: $1,000,000 / .30 = $300,000
Year five: $1,000,000 / .15 = $150,000
Total: $2,350,000
Price/Earnings Ratio: This method uses a ratio that similar business are sold at versus their cash flow to determine the value of the company.
The Breakdown:
Cash flow: $100,000
Rate: 2.50
Cash flow * rate = Valuation for Price/Earnings Ratio
$100,000 * 2.5 = $250,000
The Takeaway: Depending on what your buyer wants various valuation methods may give a more complete picture of your company.
– The Business Team
Scott | Josh | Jeremy
The Allen Firm, PC
181 S. Graham Street | Stephenville, Texas 76401
Ph: 254.965.3185 | Fax: 254.965.6539