“If business schools could offer just one course, it would not be on stock trading, the efficient market hypothesis or modern portfolio theory. Rather, B-schools should be encouraging students to learn the boring, but critically important, discipline of business valuation.” 

Quote attributed to Warren Buffet by Steve Parrish, Contributor to Forbes

All businesses Must Ultimately be Valued

All business ownership interests owned by individuals must ultimately transfer to another owner.  Even business ownership interests owned by institutions will likely be transferred at some point.

The most important factor in any transfer is price.  In the case of widely traded public companies, the price for normal day-to-day share transfers is easily determined almost instantly.  Even with large public companies, however, some unusual transactions like the transfer of major blocks of shares or tender offers have prices that differ somewhat from the normal public market price.

Valuation of Closely Held Businesses is Complex

For closely held companies the problem of determining price is significantly more difficult because there is no readily available market for the owners’ shares.  A formal business valuation requires sophisticated professional analysis.   Even so, the professional valuation is an estimate of “true value”.

The basic standard of fair market value is:

“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. “

This is the standard used by buyers and sellers, including ESOP trustees.  It is also the value used by the Internal Revenue Service and the Department of Labor.

This is only the theoretical underpinning of valuation, however.  It is not very helpful in a real life valuation because there are many  “relevant facts” that vary dramatically based on the characteristics of the buyer, the seller, the business and the market in the individual case.  So, for example, the fact that heirs of a business must sell the business quickly or that the buyer believes that purchasing a business will enhance the seller’s market position or the fact that some buyers (like ESOP trustees) are “financial buyers” are “relevant facts” that will affect value.

Another way to visualize value is to think of it as the expected economic benefit that the business will produce for the buyer after adjusting for the likelihood that the economic benefit will actually occur.  Measuring likelihood or “volatility” is also complicated and requires substantial analysis.

Owners Can Estimate “Fair Market Value” In Many Ways

Basic Valuation Principles:

Even though formal valuation is complex,  a business owner can be be aware of basic valuation principles that will determine the value of  the business for retirement planning, disability planning, estate planning and in the event of a sale of the business.

Valuation firms generally balance three approaches when they determine their estimate of the amount your business is worth:

• The Asset Approach answers the question:  “What would it cost to buy or create the tangible and intangible assets necessary to build a similar business?”
• The Market Approach answers the question: “What would be the price of a similar business?”
• The Income Approach answers the question:  “What kind of income will I get from the business, when will I get it, and how risky is it.”

The Income Approach Usually Dominates in the Valuation of Closely Held Businesses.

Formal valuations will combine the approaches in sophisticated ways, but as a practical matter, for most closely held companies, the Income Approach will dominate.

Here is a very simple explanation of the Income Approach:

Under the Income Approach the valuation firm will determine the earnings of the business over a reasonable projection period.  The earnings will be adjusted for unusual items such as perquisites and salaries of executives that will not be present after the sale.  It will also be adjusted for the anticipated rate of growth over the projection period.  The appraiser will determine a “discount rate” to account for the volatility (risk) of the cash flows by comparison with risk-free investments such as US government obligations.  Subtracting the growth rate from the discount rate determines the capitalization rate.  The reciprocal of the capitalization rate is the “multiple” by which free cash flow is multiplied to determine value for the entire business.  So, for example, if the discount rate is 25% and the growth rate is 5%, the capitalization rate is 20% and the multiple is 5 (20% divided by 100%).  Such a business would be valued at 5 times earnings.  Discount rates and projected earnings are not static, and they vary as a result of many factors including the performance of the economy as a whole.

SO, WHAT IS MY BUSINESS WORTH?

How can I figure this stuff out for myself?

• Ask somebody who is familiar with the sale of businesses about current multiples.  Fortunately, most professionals with recent experience in the world of business sales have an idea about current multiples of earnings. Often these multiples are based on EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). For example, if you determine that your EBITDA is $1 million and an experienced CPA or attorney tells you that she’s seeing Multiples of 4 to 6 times EBITDA, you can reasonably estimate that your business is worth between $4 million and $6 million.
• Apply the multiples common to your own industry.  Some industries have commonly used multiples for estimating the value of businesses.  These multiples may not be based on EBITDA, but they may be based on revenue, sales or other measures.   For example, cellular telephone companies were once valued principally by the number of subscribers they had.
• Ask a qualified valuation firm for a “Preliminary Valuation”.  If there is no particular transaction or other reason for a valuations, many professional valuation firms will perform quick, non-binding valuations at a relatively low price.
• Use one of the emerging “expert systems” that use software programs to emulate formal valuations and give you suggestions about how to improve your value.  Even though the results of these programs will not satisfy the Internal Revenue Service or the Department of Labor, some of them are quite sophisticated.  The more advanced systems will allow you to change the characteristics of the valuation model to show you how you can increase the value of your business.  CoreValue software is a program that performs such a function.  If you wish to explore the CoreValue Software in greater depth, it is available through our  value partner Bruce Peters at WCEOHQ:  *protected email*.  Bruce will guide you briefly about the use of the software, but you will then be free to use it privately for one year to explore ways to increase the value of your business.  The cost to use the software for one year is $2,500.  The founders of CoreValue software have published articles about business valuation including Minority Discounts (the Control Premium) and Discounts For Lack of Marketability.

Controlling interests in companies are worth more than minority interests.  For this reason in any transaction that results in the transfer of a minority interest will have a lower price.  Technically, the minority interest is sold without a “control premium”, but most people call the phenomenon a “minority discount”.  (Note that the everyday price of the shares of a widely held publicly traded company is a minority interest.)  This is one reason why the price in tender offers may be higher.

It is easier to sell the shares of a widely held publicly traded corporation than it is to sell the shares of a closely held corporation.  For this reason, shares of a closely held company may be further dicounted for illiquidity or “lack of marketability”.

The combination of these discounts can be substantial, and they must be taken into account depending on the type of transaction.