Expert: Gary Bell - 9/23/2005

Question
Greetings.  I was hoping you could provide a 'rule-of-thumb' that would help me determine the approximate value of an ongoing business.  This would be a great help to me for retirement planning, etc.  Any advice you could offer will be appreciated - thanks.   Larry

Answer
Larry,

The process of valuing your business is complex. You must take into account both the projected revenue/earnings of your business and its market position. Also, if you have a unique business model, that can increase its valus. I always suggest business owners hire competent, experienced consultants (attorney/CPA) who do valuations for a living. Business brokers can be helpful, but I advise caution about reliance soley on their judgement as "making a sale" is their big objective. (Think of allowing a real estate broker to set the value of your home;you'd want an independent appraisal.) There's tons of informative material on the internet.

Here's an excellent article taken from
http://finance.asinah.net/finance/business_valuation.html

"A business valuation determines the price that a hypothetical buyer would
pay for a business under a given set of circumstances. The valuation of a
business is a complex and time-consuming undertaking and yet the volume of
business valuations being performed each year is increasing significantly.
A leading cause of this growth in volume is the increasing use of mergers
and acquisitions as vehicles for corporate growth. Business valuations are
frequently used in setting the price for a business that is being bought
or sold. Another reason for the growth in the volume of business
valuations has been their increasing use in areas other than supporting
merger and acquisition transactions. For example, business valuations are
now being used by financial institutions to determine the amount of credit
that should be extended to a company, by courts in determining litigation
settlement amounts and by investors in evaluating the performance of
company management. Lastly, business valuations are often required under a
variety of accounting and tax regulations that are not directly related to
mergers and acquisitions.

In most cases, a business valuation is completed by an appraiser or a
Certified Public Accountant (hereinafter, appraiser) using a combination
of judgment, experience and an understanding of generally accepted
valuation principles. The two primary types of business valuations that
are widely used an d accepted are income valuation and asset valuations.
Market valuations are also used in some cases but their use is restricted
because of the difficulty inherent in trying to compare two different
companies.

Income valuations are based on the premise that the current value of a
business is a function of the future value that an investor can expect to
receive from purchasing all or part of the business. Income valuations are
the most widely used type of valuation. They are generally used for
valuing businesses that are expected to continue operating for the
foreseeable future. In these valuations the expected returns from
investing in the business and the risks associated with receiving the
expected returns are evaluated by the appraiser. The appraiser then
determines the value whereby a hypothetical buyer would receive a
sufficient return on the investment to compensate the buyer for the risk
associated with receiving the expected returns. Income valuation methods
include the  apitalization of earnings method, the discounted future
income method, the discounted cash flow method, the economic income method
and other formula methods. Asset valuations consider the business to be a
collection of assets which have an intrinsic value to a third party in an
asset sale. Asset valuations are typically used for businesses that are
ceasing operation and for specific type of businesses such as holding
companies and investment companies. Asset valuation methods include the
book value method, the adjusted book value method, the economic balance
sheet method and the liquidation method.

Market valuations are used to place a value on one business by using
valuations that have been established for comparable businesses in either
a public stock market or a recent transaction. This method is difficult to
use properly because no two companies are exactly the same and no two
transactions are completed for the exact same reasons. Market valuation
methods include the price to earnings method, the comparable sales method,
industry valuation methods and the comparable investment method.

When performing a business valuation, the appraiser is generally free to
select the valuation type and method (or some combination of the
methods)in determining the business value. Under the current procedures,
there is no correct answer, there is only the best possible informed guess
for any given business valuation. There are several difficulties inherent
in this approach. First, the reliance on informed guessing places a heavy
reliance on the knowledge and experience of the appraiser. The recent
increase in the need for business valuations has strained the capacity of
existing appraisal organizations. As a result, the average experience
level of those performing the valuations has decreased. The situation is
even worse
for many segments of the American economy where experienced appraisers
don't exist because the industries are too new. Another drawback of the
current procedures for completing a valuation is that the appraiser is
typically retained and paid by a party to a proposed transaction. It is
difficult in this situation to be certain that the valuation opinion is
unbiased and fair. Given the appraiser's wide latitude for selecting the
method, the large variability of experience levels in the industry and the
high likelihood of appraiser bias, it is not surprising that it is
generally very difficult to compare the valuations of two different
appraisers--even for the same business. These limitations in turn serve to
seriously diminish the usefulness of business valuations to business
managers, business owners and financial institutions.

The usefulness of business valuations to business owners and managers is
limited for another reason--valuations typically determine only the value
of the business as a whole. To provide information that would be useful in
improving the business, the valuation would have to furnish supporting
detail that would highlight the value of different elements of the
business. An operating manager would then be able to use a series of
business valuations to identify elements within a business that have been
decreasing in value. This information could also be used to identify
corrective action programs and to track the progress that these programs
have made in increasing business value. This same information could also
be used to identify elements that are contributing to an increase in
business value. This information could be used to identify elements where
increased levels of investment would have a significant favorable impact
on the overall health of the business.

Another limitation of the current methodology is that financial statements
and accounting records have traditionally provided the basis for most
business valuations. Appraisers generally spend a great deal of time
extracting, aggregating, verifying and interpreting the information from
accounting systems as part of the valuation process. Accounting records do
have the advantage of being prepared in a generally unbiased manner using
the consistent framework of Generally Accepted Accounting Principles
(hereinafter, GAAP). Unfortunately, these accounting statements have
proved to be increasingly inadequate for use in evaluating the financial
performance of modem companies.

Many have alleged that traditional accounting systems are driving
information-age managers to make the wrong decisions and the wrong
investments. Although, it is important to note that the decisions are made
by managers and not the information systems themselves. Accounting systems
are "wrong" for one simple reason, they track tangible assets while
ignoring intangible assets. Intangible assets such as the skills of the
workers, intellectual property, business infrastructure, databases, and
relationships with customers and suppliers are not measured with current
accounting systems. This may be critical because the success of an
enterprise is increasingly determined by its ability to use its intangible
assets than by its ability to amass and control the physical ones that are
tracked by traditional accounting systems. In contrast, it should be noted
that while many theories of how to value intangible assets have been
noted, none have become established as a standard.

The recent experience of several of the most important companies in the
U.S. economy, IBM, General Motors and DEC, illustrates the problems that
can arise when intangible asset information is omitted from corporate
financial statements. All three were all showing large profits using
current accounting systems while their businesses were falling apart If
they had been forced to take write-offs when the declines in intangible
assets were occurring, the problems would have been visible to the market
and management would have been forced to act on them much sooner. These
deficiencies of traditional accounting systems are particularly noticeable
in high technology companies that are highly valued for their intangible
assets and their options to enter new markets rather than their tangible
assets.

The dependence on accounting records for valuing business enterprises has
to some extent been a matter of simple convenience. Because corporations
are required to maintain financial records for tax purposes, accounting
statements are available for virtually every company. At the same time,
the high cost of data storage has until recently prevented the more
detailed information required for valuing intangibles from being readily
available. In a similar manner, the absence of integrated corporate
databases within corporations and the home-grown nature of most corporate
systems has until recently made it difficult to compare similar data from
different firms.

The lack of a consistent, well accepted, realistic method for measuring
all the elements of business value also prevents some firms from receiving
the financing they need to grow. Most banks and lending institutions focus
on book value when evaluating the credit worthiness of a business seeking
funds. As stated previously, the value of many high technology firms lies
primarily in intangible assets and growth options that aren't visible
under traditional definitions of accounting book value. As a result, these
businesses generally aren't eligible to receive capital from traditional
lending sources, even though their financial prospects are generally far
superior to those of companies with much higher tangible book values."

I wish you well and urge you to take your time and prepare carefully for this life-changing moment.

Gary