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What's Your Company Really Worth?

Going for growth? This number will help you get up to speed.

What's your company worth to an outside buyer? Even if you have no intention of selling, knowing its range of value can be important, especially when it comes to estate planning, selling or gifting stock, or establishing a succession plan via stock ownership.

To ensure a fair value, the tax code requires at least two approaches be used.

The following options are recommended for product-oriented companies that carry a strong inventory, focus on a specialized customer base and receive repeat sales, such as retailers and distributors.

  1. Asset-Based Valuation. Also known as "adjusted book value," this begins with the company's hard assets, such as accounts receivable and inventory, and deducts real estate (which is usually listed on the books at its purchase price less depreciation). To that is added goodwill, which represents how much the company is earning beyond the amount expected from a reasonable return on the dollar value of its assets.

    Elements of goodwill include: company age, employee turnover, value of the company's suppliers, value of the products sold, market area, potential growth, inventory efficiency, location and banking relationships. Goodwill is calculated by determining a fair return on investment based on subtracting the company's total assets from its true earnings. (See related story.)

  2. Capitalization of Earnings. This isn't the best approach for private companies because tax laws offer no incentive to report high profits. Federal tax law states that a valuation should be based on five years of tax returns, with each income and expense item evaluated and added back in as appropriate. Abnormal expense items also are eliminated to create a true annual profit.

    Note: Although a handful of evaluators consider profit to be the earnings before taxes, it makes sense to deduct taxes because they must be paid, and they're a legitimate yearly expense.

    The new five-year profit figures are given a weighted average (that is, the most recent is multiplied by five, the next-most recent by four, and so on, with the final total divided by 15). From that, the company's earning capacity is projected for five years into the future — a difficult activity in any economy. This requires analyzing the industry's growth rate, capitalization rate, cost of capital, general economic outlook and other factors — a process that could be considered far more art than science.

  3. Cash Flow/Leveraged Debt. This represents a variation on the earnings method. It calculates the company's value based on how much money the owners could borrow if they borrowed money to buy the company and used the company's income to pay the interest on the loan. In essence, it represents the maximum amount an outsider would pay to buy the company if he planned to leverage the company's operating income to finance the acquisition.

    To calculate it, take the existing tax rate, add 1 to it and then multiply that result by the average weighted annual income derived from valuation No. 2 above, adjusted for cash flow. That result is divided by the current interest rate, with the company's total debt subtracted.

  4. Comparable Sales. In this method, the company compares itself to other recently sold businesses with similar sales volumes and types of products. This works especially well in industries where many companies are being acquired or merged. But it's often difficult to learn the purchase price for privately held businesses. IRS rules further require that at least three comparable companies be used to make this format effective.

In arriving at a final value, the various valuations generated using the above methods are combined, using a weighting to emphasize the one deemed most representative of the company's true worth. For instance, if three forms are used, one can be given 50% of the total, while the other two can be split to make up the other half.

Writer: Craig A. Shutt interviewed Bart Basi, president of the Center for Financial, Legal & Tax Planning Inc. in Marion, Ill., who created the cash-flow/leveraged-debt model for valuing a product-oriented company.

This article was originally published in the April 2000 issue of The Edward Lowe Report.

Determining Goodwill

One way to determine the goodwill in a company with hard assets of $1 million is to examine the expected annual return for investing $1 million. At 15%, that would be $150,000 per year. If the company nets $190,000, that $40,000 differential can be credited to goodwill.

The long-term asset value of that goodwill can be determined by calculating how long it would take an investment to cover that $40,000 additional return. At a 15% return, it would require $266,667 to receive $40,000 annually. Thus, the company's true worth, with goodwill included, is $1.27 million — that is, that much invested at 15% interest would produce the company's return of $190,000.

Another approach: Calculate the capitalization of earnings (method No. 2), and subtract the normal earnings for a similar company using industry standards. Then add that total to what is calculated as the company's asset-based valuation (method No. 1).

Calculating Value

  • Asset-based valuation: assets at book value +/- adjusted fair-market value of assets - excess depreciation +/- other adjustments (LIFO, etc.) + off-balance-sheet activities = gross adjusted book value - liabilities = net adjusted book value + goodwill = total net adjusted book value (including goodwill)

  • Average weighted annual income = ((1999 profits X 5) + (1998 profits X 4) + (1997 profits X 3) + (1996 profits X 2) + (1995 profits X 1)) / 15

  • Cash flow/leveraged debt = (((tax rate + 1) X average weighted annual income) / interest rate) - total debt of the company

  • Goodwill = one year's earnings - (value of hard assets X expected interest rate of investment capital)

  • Long-term asset value of goodwill = goodwill / expected interest rate of investment capital

  • Company's true worth = hard assets + long-term asset value of goodwill
Related Information
The Upstart Guide to Buying, Valuing and Selling Your Business.

Resources

U.S. Jobs 2006-2008
U.S. Jobs 1993-2008
Littleton Economic Gardening
Kauffman Foundation Research

Chris Gibbons: Introduction to Economic Gardening Chris Gibbons Intro to EG
Mark Lange: Economic Gardening Update for Collier County, FL (Naples) Mark Lange EG Update

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