05 Apr Valuing Assets: Part 1
by George D. Abraham
CEO & Chief Appraiser
Business Evaluation Systems
Most individuals involved in selling and or appraisal of complete companies usually underestimate the importance of the fair market value of the assets of the business. Many appraisers and intermediaries merely rely on “Book Value” or the owner’s best estimate and even an arbitrary discount or premium based on the type of asset involved. The theory of not really doing a value analysis on the assets is mainly derived by the assumption that the business is worth what the market will pay, or in other words its “Fair Market Value” and that the assets are merely the basis for producing the income stream. It is also a common philosophy that because goodwill is the difference between the assets and the company’s fair market value, that if you are slightly off on the value of the assets, the only factor influenced is that the company will show more or less intangible value, but the fair market value of the complete business is still the same.
If you look into the accepted approaches that are used to value businesses, several aspects begin to cloud the above scenario. For instance, appraisers do, and should use historical as well as projected financial analysis to normalize discretionary net profit. Correctly done, the cost of new equipment to handle future increases in revenues for the business in the projected years and a deduction for true (sometimes called economic depreciation or a capital reserve) depreciation for historical years to arrive at a true earnings picture of the company. If the costs of the assets are off, keep in mind that at a capitalization rate of 25%, every one thousand dollars of discretionary net profit can equal 4 times that amount when capitalizing the income, thereby having a drastic impact on the overall value of the company.
Another aspect that one must consider is that many of the calculations in the various approaches take into consideration the value of the assets. Those that are not directly impacted by methodology involving the assets are still derived from capitalization of the income stream, and as stated above can result in some drastic differences in value. One of the most popular methods used by intermediaries and appraisers is a combination of assets plus a multiple of earnings, or mainly just a multiple of earnings associated with the type of business being valued. Almost all accepted methodology relies on the normalized income stream. Again, assets can play a significant role in the overall estimate of value of the business. Depending on the size of the company and the various methods used, an error in valuing the assets can have more of an effect than one might think. Also, although most business appraisers do not value the real estate, one must be thorough to research this asset to determine the fair market rent to be deducted from expenses to allow the real estate to be added to the fair market value of the company as an “Investment Value”.
Tomorrow’s blog entry will continue this article with a discussion of various categories of hard assets.
The above article was written by George Abraham, an experienced business broker who is now a well-known business appraiser. Since 1973, Business Evaluation Systems has been involved in the appraisal of over 16,000 companies, covering almost every industry on a national and international basis, ranging in value from $50,000 to over $7 billion. The firm provides third-party valuations as well. For more information go to: www.BESappraisals.com