Feature Article

The Price is Right. Right?

The primary principle that one needs to understand in determining the selling price of a business is that there is no right or wrong selling price. The final sale price or the purchase price of a business is entirely dependent on how much the buyer wants to pay for the business and how much the seller is willing to sell his business for. But irrespective of this, one needs to know how much to ask for the business.

There are multiple ways of determining the asking price of a business. A starting point could be the value of similar businesses in the same industry or sales statistics from business brokers. A very effective method is employing a professional valuator who will propose using one of several valuation approaches, including asset based, income, and market approaches. The approach used is typically dependent upon the type of business being valued.

Within the three approaches, the commonly used methods of valuation include

• Adjusted net assets method: This method considers the difference between the fair market value of a companys assets and liabilities. It is commonly used to value non-operating businesses (e.g., holding or investment companies) or businesses that currently operate at a loss or do not have consistent levels of earnings from period to period (e.g., start-up companies).
  
• Discounted cash flows method: This method of valuation uses the present value of projected future cash flows to determine the value of the business. The projected cash flows are discounted to their present value using a discount rate that corresponds to the amount of risk involved in the company achieving the projected cash flows.
  
• Capitalization of earnings/cash flows method: Under this method, the estimated future earnings or cash flows of the company are capitalized by the required rate of return to compensate for the risk in the business. This method is more commonly used when the future earnings or cash flows are expected to be stable or grow at a steady rate.
  
• Excess earnings method: This method combines the asset and income approaches to valuing a business. In essence, the value of a business equals the sum of the value of the adjusted net assets and the intangible assets of the entity. The intangible asset value is determined by capitalizing the earnings of the company that exceed a reasonable return on the adjusted net assets of the business.
  
• Transaction based methods: The value of a business can be determined by considering actual sales of other companies in the same line of business as the subject company. Three sources of comparable data include (1) public company transactions, (2) private company transactions, and (3) prior transactions of the subject company. When the sales price for other transactions are known, a valuator can determine various multiples of key financial data to then apply to the subject company in order to estimate the value of the entity. Popular multiples used to value a business include price to earnings, price to cash flows, and price to revenues, among others.

Valuation as we know is an extensive exercise. Though there may be multiple valuation methods which may be easily identifiable and applicable, it is always advisable to route the process through a valuation professional. It is imperative that one understands the appropriate method of valuation to be applied to the business to ensure the seller has the opportunity to ask for the right price for the sale of his business.

For more detailed information please contact:

Richard Millman, CPA/CFF/ABV, CVA
richard.millman@hawcpa.com

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