Understanding the Value of Your Company
An Overview of Business Valuation
How much is your company worth? Certainly, an important question, and unfortunately, it is one that many business owners cannot easily answer!
First let’s start with a discussion about why it is so critical to understand the value of your company. There are many reasons to understand the value of your company, including planning for growth in value, internal ownership transition, merger with another company, outside sale of your company, and even acquisition of another company!
Growing the Value of Your Company
If you know the value of your company and understand the critical factors that influence its value, that should better allow you to manage your business to produce not only current earnings but also increase the company’s long-term value. A specific target value can be set for some future point, such as the retirement of key shareholders. Goals and strategies can then be established to help achieve this target value.
Internal Ownership Transition
When you transition ownership within your company, you are really transitioning value. To understand the amount in dollars that must be bought and sold, as a starting point, you must know the value of your company. From there, you can begin to consider how to best plan for transition of that value. There are many opportunities and complexities in planning for internal ownership transition. Whether ownership is sold to key employees or gifted to a next generation of family members, the ownership transition process begins with determining the value of the business.
Merger or Outside Sale to Another Company
Sure, most companies are not actively being marketed, however for the right price just about any owner would consider a deal! It is important to understand the value of your company so that you can evaluate any offers you might receive. Many industries have been very healthy in recent years, and this has increased company values and the ability of acquiring companies to consummate an acquisition.
Acquisition of Another Company
Yes, it is also important to know the value of your company if you are looking to acquire another company. How you view the value of your company will help you to understand the potential value of a target company. In addition, an acquisition might be paid for with your company’s stock so a value will be needed to determine the number of shares to exchange.
Determining the value of your company
There are several different ways that businesses determine the value of their stock or ownership shares. These range from educated guesses to values based on an established formula to detailed valuation reports prepared by qualified appraisers. Following is a summary of some common methods for determining business value along with comments on their application and usefulness.
It is very common for small businesses to use book value as their method of determining the value for share transactions. However, business is usually worth much more than its book value! Even if your accounting is properly performed on an accrual basis, book value only includes tangible assets and represents nothing more than liquidation value if you collected your receivables, paid your payables, and sold off other assets. Surely your company is worth more than just its liquidation value!
Capitalization of Earnings
Businesses can also be valued by assigning a valuation multiple to “capitalize” the historical or projected future earnings of the company. Depending on the type of earnings that is utilized in this calculation, an appropriate valuation multiple might be in the range of three to seven times. This type of valuation will only be effective if a company’s earnings are “normalized” to addback discretionary expenses and adjust for other nonrecurring income or expense.
Adjusted Book Value Plus Goodwill Approach
While book value is not by itself sufficient to determine value, consideration must be given to the value of the assets retained in the company. Under the adjusted book value plus goodwill approach, the adjusted book value represents the floor value or starting point in determining value. To this base value, an earnings or goodwill factor is added to determine the overall value of the business. The earnings factor is most often determined by capitalizing the weighted average earnings of the company for the most recent five-year period. This hybrid approach was developed years ago by Dannible & McKee years ago and it has been successfully utilized to value hundreds of businesses across the U.S.!
Industry Rules of Thumb
There are a number of “rule of thumb” valuation multiples that are talked about in various industries. These are generally not sufficient to rely upon in determining value as they ignore many of the individual characteristics of a company. However, they can provide a great sanity check in support of other more detailed valuation methods. Some industry rules of thumb are based on a multiple of annual or monthly revenue, while others might use multiples of non-financial factors such as the number of employees, number of operating locations or capacity.
Impact of the Pandemic on Company Valuations
The COVID 19 pandemic had a dramatic impact on the 2020 operating results for many businesses. Additional scrutiny will be needed to determine how this unusual year may have impacted the company’s valuation. While operating profits were generally lower, for many companies this was more than offset by Paycheck Protection Program (PPP) loan proceeds and forgiveness, possibly resulting in a growth in book value. These items require careful consideration in determining whether the methods used, and value determined for the company is still appropriate.
I hope this article has helped to show the importance of knowing the value of your company and provides at least a starting point to understanding how that value might be determined. Visit our business valuation page to learn more about valuations and our valuation services. If you would like to discuss the valuation of your company, feel free to reach out to me anytime at firstname.lastname@example.org or 315-472-9127 x220.
Contributing author: Victor W. Vaccaro, Jr., CPA/ABV, CFF, CDA, is an audit partner with 31 years of experience providing auditing, accounting and consulting services. Vic’s areas of expertise include FAR overhead audits, business valuations, ownership transition, mergers and acquisitions and forensic accounting.