By Daniel S. Hughes, CPA/CFF, CGMA, CVA
Business owners already struggling with the continued uncertainty surrounding the pandemic are also facing the prospect of higher taxes and a resulting negative impact on company cash flow, profitability and valuations. For some, this environment will accelerate business sales or mergers and require significant alterations to existing estate plans – all of which will require business valuations.
There are many instances when a business valuation is beneficial and even required to assess a company’s realistic economic worth or fair market value (FMV) at a particular point in time. This can occur when seeking out loans, becoming involved in litigation or corporate disputes or when engaged in succession planning. However, because a business’s value is so closely tied with the owner’s personal wealth, a valuation also can be useful in estate and gift planning, prenuptial planning, divorce litigation and in a range of other tax-related situations.
Defining a business’s value, however, is not as easy as looking at its balance sheet and income statement. Rather, a formal appraisal of the business will consider more factors and reveal far more detail required to help owners make informed decisions about their ongoing operation and continued success.
Methods of Business Valuation
There are three fundamental approaches to arriving at the value of a business: an income approach, a market approach or an asset approach. The approach one employs will often be determined by the type of business being valued and where the business is in its lifecycle. While it is not uncommon for appraisers to employ a combination of all three approaches, business owners should have a keen knowledge of what is involved with each.
The income approach to valuation aims to measure the present value of a business’s future income and cash flow in today’s dollars. It forecasts the company’s future earnings power by considering its historic and present income, cash flow, and expenses, as well as the capital it will need to maintain operations into the future. By relying on this record of business performance as a foundation for future projections, the income approach tells individuals holding an interest in the company, what risks, returns or benefits those investors can expect in the future.
Typically, the income approach is best applied to operating businesses, where value is added to products or services from labor and intangible assets. This can include businesses in the manufacturing, retail and wholesale industries.
The market approach takes a broader look at the industry in which a business operates and compares that company’s performance to those of similar entities. Just as home sellers will look at recent sales of comparable properties to determine a fair sales price for their homes, business appraisers applying a market approach in a business valuation can look at sales of comparable businesses or guideline public companies in the same industry. By using this empirical evidence to determine benchmarks and apply industry multiples, business appraisers can arrive at an appropriate market value of the business.
The third method for valuing a business is the asset approach, which considers the fair market value of the underlying assets the business owns, minus the business’s liabilities. The appraisal begins with an assessment of the company’s balance sheet. A value is determined for each asset and liability and adjustments are made when deemed necessary. Often, this approach will require separate appraisals for equipment and real property owned by the business.
The utilization of appropriate valuation approaches should be left to the professional judgment of an experienced valuator. A qualified business appraiser is able to support his or her conclusion to correctly value a business and provide significant benefit to the client. The Forensic and Advisory Services team at Berkowitz Pollack Brant has a broad range of experience in conducting business valuations.
Daniel S. Hughes, CPA/CFF, CGMA, CVA