Many business owners wonder what their company is truly worth in today’s market. And that’s not a bad question to ask, whether you’re making day-to-day operating decisions or considering the future of your company.
Generally speaking, there are three scenarios that call for a valuation: tax planning; a transfer of ownership; and the sale of a business. Even if those don’t apply to you, a valuation never hurts. Often, the process will provide some great insights into what’s driving and detracting from your business—and that’s useful information if you want to increase your company's worth or set yourself up for growth.
Regardless of your reason for needing a valuation, the IRS—which regulates valuations performed for tax-planning purposes—dictates that eight factors should be considered:
- The nature of the business and the history of the enterprise from its inception
- The economic outlook in general and the specific industry in particular
- The book value of the company and the financial condition of the business
- The earning capacity of the company
- The dividend-paying capacity of the company
- Whether the enterprise has goodwill or other intangible value
- Sales of the stock and size of the block to be valued
- The market price of stock of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter
There isn’t a one-size-fits-all formula when determining value. You’ll need to select one of three basic approaches: the asset approach, the market approach or the income approach. The route you take should be based not only on the purpose of your valuation, but also on the nature and state of your company and industry.
- Typically, the asset approach is used for distressed businesses that will continue to generate loss or will be liquidated in the near future. It also can be used for holding companies and investment companies. Based on the balance sheet, this approach is essentially the sum of a business’s tangible and intangible assets.
- The market approach is a common way to value a large, healthy business that is considering a potential transaction. It ascertains value through comparison: your company will be evaluated against similar businesses—for example, in the same industry, of the same size, or in the same geographic area—which theoretically could qualify as alternative options for an acquirer.
- Finally, the income approach values a company based on its generated income. Two essential methods fall under the income approach, and each has variations depending on what measure of income will be discounted or capitalized. One form of the income approach is single-period capitalization, which involves forecasting one typical future year. Another form of the income approach is multiple-period discounting, which forecasts anywhere from three to 10 years (or more, in some cases).
When applied to the appropriate situation, the asset approach, market approach and income approach are equally valid, and each has a theoretical justification. Knowing how to select an approach and perform the process, however, comes with a bit of a learning curve.
And you may need to take it a step further. Some factors don’t affect your company’s value as a whole but do affect the value of individual shareholders’ interests, such as marketability and control. The valuation approaches don’t account for these variables, so “discounts and premia” should be calculated and subtracted from your company’s total value as appropriate.
Technically, anyone can perform a valuation—extensive tools and resources are available to help you complete the process. But many business owners find it difficult to view their companies with the objectivity that an accurate valuation requires. In some situations, an improper valuation can be challenged in court, so it’s important that yours is logical, valid and defensible. Most importantly, keep in mind that valuations are an imperfect science; when judgment calls are required, it helps to have experience on your side—so if you have questions, don’t hesitate to give the professionals here at FourBridges a call.