Art and science

guest commentary by David Potts

This commentary, admittedly, is somewhat clinical, but it is important if you want to understand how to increase the value of your business, our theme for the next few weeks. Today we will outline an appraiser’s approach in determining his opinion of value for a privately owned company.

Valuing a business is both art and science. It is science in that an appraiser uses mathematical formulas and tried and true methods in appraising a business’ value. It is art in that it takes judgment and experience to apply these formulas and methods correctly. An appraiser also has to be a bit of a fortuneteller because the value of a company is determined by the future economic benefits derived from owning the business. The past is used only as a guide to the future.

So where does a business appraiser start his analysis. First he must know the date for which the company is to be valued. Observations of the values of stocks on the New York Stock Exchange demonstrate that the value of a company changes through time based on market forces. This is true for both publicly traded companies and privately owned companies. So a static date must be determined.

Next, the definition of value must be determined. We will limit our discussion to fair market value as defined by the Internal Revenue Service in Revenue Ruling 59-60 which states the fair market value of an item of property is "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts." From the appraiser’s point of view the willing buyer and willing seller are hypothetical people. They are the people that make up the “market.” It’s the appraiser’s challenge to interpret the market. People who buy and sell business interests are the market makers.

An appraiser considers three approaches in his analysis to determine a company’s fair market value. These approaches are referred to as the market approach, the income approach, and the asset approach. There are different methods under each of these approaches, so think of an approach as the underlying principles or theory supporting the method.

The market approach is simple to understand — deceptively simple. Anybody who’s ever bought or sold a house understands how the market approach works. If you want to know the value of a house you want to buy or sell, you compare it to a house that is already sold to arrive at your opinion of value. It works the same way for a business. The idea behind the market approach is that the fair market value of the business can be determined by reference to a guideline company for which the value is known. It is just a lot easier to compare houses than businesses. However once you have determined that you have found a comparable company, you simply take a multiple of the price to a parameter of the comparable company and apply it to the subject company to determine its value. The parameter on which the multiple is based is normally something such as sales, earnings, or book value — e.g. price to earnings or the PE ration.

The asset approach indicates the value of the business by determining the fair market value of its assets and subtracting its liabilities. From the appraiser’s point of view assets include balance sheet assets and off balance sheet assets, tangible assets as well as intangible assets. Liabilities include income tax on the unrealized gains between the fair market value of the assets and their income tax basis. Because of the difficulty of valuing intangible assets such as goodwill and the expense of appraising individual assets, is generally more feasible to use the market approach or the income approach to value an operating company.

The income approach is based on the time value of money, the risk of the investment, and the expected rate of inflation. The three primary valuation methods based on the income approach are the discounted cash flow method, the capitalized cash flow method, and the excess cash flow method. These methods are based on determining a future benefit stream, generally cash flow. I’ll discuss these methods in more depth in the future. Just keep in mind that the value of a business indicated by the income approach is (restated a bit differently than above) based on the cash flow a business can generate, the growth rate of the business, and the discount rate. The discount rate reflects the rate of return required to attract buyer’s to a business with its level of perceived risk.

An appraiser may use one or all three approaches in arriving at his opinion in the value of a privately owned company. If he uses more than one approach he must reconcile the different values reached using the different approaches. Adjustments also may have to be made to recognize other ownership characteristics — e.g., whether the interest being valued is a control interest or a minority interest and/or whether there are restrictions on the transfer of an ownership interest. Many things can affect the value of the company. In future commentaries we will discuss ways to increase the value of your company in less clinical terms. But an understanding of the valuation approaches discussed above will give our discussions context and structure to understand why choices you make in your business can increase your business’ value and your wealth.

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]