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Best Buisness Valuation

    Gjergj Kol Mihilli
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    By Gjergj Kol Mihilli

    Best Buisness Valuation Formula For Your Buisness/Gjergj Kol Mihilli

    As you prepare to sell your business, you've taken a number of steps:

    • You've examined your company's historical financial statements.
    • You've carefully considered the prospects for future growth
    • You may have had your accountant recast your statements to reflect how new ownership would affect your company's earnings and cash flow.
    • You've also considered the market value of any real estate, equipment, inventory, and other hard assets that would be transferred in the sale, as well as the intangible aspects that make your business appealing.

    Now, how do you boil all of this down into an asking price for your business?

    In order to ensure that you get the best price for your business, it is wise to hire an expert business appraiser. The appraisal process can be very complex and time-consuming. It takes quite a lot of experience to do well.

    There are a number of valuation methods that business appraisers have at their disposal, and even choosing the correct method (or more likely, the correct combination of methods) to use in a given situation is more of an art than a science. The following discusses the major approaches commonly used to put a price tag on small businesses. Our objective here is simply to give you high-level insights into the process that your appraiser will be go through.

    Business valuation methods fall into the following categories, depending upon their major focus:

    • business assets, including book value and liquidation value methods
    • historical earnings, including debt-paying ability, capitalization of earnings or cash flow, gross income multipliers, and dividend-paying ability methods
    • a combination of assets and earnings, namely, the excess earnings method
    • the market for similar businesses, including comparable sales, industry rule of thumb, and p/e ratio methods
    • future earnings, namely, discounted future cash flow or earnings methods

    Although no substitute for an appraisal and valuation by qualified professions, the Interactive Business Valuation Calculator can provide you with a rough idea of the value of your business.

    Asset-Based Valuation Focuses on Salable Parts

    At a minimum, your company should be valued at the sum of the value of its easily salable parts. Two commonly used business valuation methods look primarily at the value of your hard assets.

    Warning: If goodwill or other intangibles are a significant component of your business, relying solely on a salable parts method could could result in a serious undervaluation of the goodwill component of your business.

    Book value. Book value is the number shown as "owner's equity" on your balance sheet. Book value is not a very useful number, since the balance sheet reflects historical costs and depreciation of assets rather than their current market value. However, if you adjust the book value in the process of recasting your financials, the current adjusted book value can be used as a "bare minimum" price for your business.

    Liquidation value. Liquidation value is the amount that would be left over if you had to sell your business quickly, without taking the time to get the full market value, and then used the proceeds to pay off all debts. There's little point in going through all the trouble of negotiating a sale of your business if you end up selling for liquidation value — it would be easier to simply go out of business, and save yourself the time, broker's commission, attorney's fees, and other costs involved in selling a going concern. Thus, liquidation value is not even considered a valid floor for the price of your business (and you can use this argument in negotiations if you get an offer that approaches liquidation value.)

    Assets and Earnings Valuation  Often Used for Gift Tax Valuation

    Assets and earnings valuation, known as the excess earnings method, takes both assets and historical earnings into consideration in arriving at the value of the business. This is the method prescribed by the IRS for estate and gift tax situations when there's no other more appropriate method. It can also be used in appraising a business that's being put up for sale, although the IRS does not prescribe it for this situation.

    Since the IRS has sanctioned this method for at least some purposes, your appraiser may want to use it also, particularly if you're concerned about IRS scrutiny of your tax returns reporting the sale. You may sometimes see this method referred to as ARM 34, which is what the IRS calls it.

    To use this method, you must first recast your historical financials to show how the business would have looked without the owner's excess salary and perks (that is, the amount over and above what a non-owner manager would have been paid), non-operating or nonrecurring income/expenses, etc.

    For the income statement, a judgment call must be made as to whether you should look only at the last year's statement, or at some combination of statement results from the last three to five years (the most common combinations are a simple average, a weighted average that values the most recent years more heavily, or a trend line that factors in the percentage and direction of growth each year). The IRS prefers to see figures that represent a five-year average, which seems to be a reasonable approach.

    For the balance sheet, use the most recent month's sheet, recast to reflect current market value. The starting point for the value of your business is the net value of your assets as shown on the recast balance sheet. But how much more should you get, based on the business's goodwill or intangible value?

    Putting a price tag on goodwill. From your recast financials you can determine your historical annual earnings figure (generally, EBIT or earnings before interest and taxes). From this you'll subtract the portion of earnings that's attributable to your assets alone. Anything left over is the "excess earnings" — the portion that's attributable to the going-concern value of the business.

    How do you determine the portion of earnings that are attributable to your assets? One way of looking at this is, if the assets were sold and the money invested at market rates, how much could you get? How much is the market paying for other investments of similar risks? This is one of many areas where the expertise of a professional business appraiser can be invaluable.

    For example, your appraiser might say that, in view of the risk involved in your particular business, your annual return from the current assets should be about 150 percent of the rate of a short-term government bond; your annual return from the long-term assets should be about 188 percent of the bond rate.

    After you compute the expected returns from your assets, compare the total with your historical earnings figure. If the historical earnings figure is higher than the return from assets, the difference is called "excess earnings." The excess earnings can be divided by a capitalization ("cap") rate to arrive at their value. Although a professional appraiser will spend a good deal of time and effort determining the proper cap rate to use, in today's market it will generally be somewhere around 20 to 25 percent, or enough to recover your investment in four to five years

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