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Business Valuation Purposes

See Also:
EBITDA Valuation
Valuation Methods
Multiple of Earnings

Business Valuation Definition

Business valuation is the process of determining the economic value of a business or company. It assesses a variety of factors to determine the fair market value in a sale, but there is no one way to verify the worth of a company. Business valuation can depend on the values of the assessor, tangible and intangible assets, and varying economic conditions. Business valuation provides an expected price of sale; however, the real price of sale can very.

Traditional approaches to business valuation employ financial statements, cash flow models, and comparisons to competitive companies within a similar field or industry.

Business Valuation Methods

Income Approach: determines business value based on income. This type of valuation focuses on net cash flow, discretionary cash flow, and capitalization of earnings.

Asset Approach: determines business value based on assets. This type of valuation focuses on asset accumulation (assets minus liabilities) and capitalized excess earnings.

Market Approach: determines business value in relation to similar companies. This type of valuation focuses on the comparative transaction method and appraises competitive sales of comparable businesses to estimate economic performance looking at revenue or profits primarily.

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

Business Valuation Purposes

Although the primary purpose of business valuation is preparing a company for sale, there are many purposes. The following are a few examples:

Shareholder Disputes: sometimes a breakup of the company is in the shareholder’s best interests. This could also include transfers of shares from shareholders who are withdrawing.

Estate and Gift: a valuation would need to be done prior to estate planning or a gifting of interests or after the death of an owner. This is also required by the IRS for Charitable donations.

Divorce: when a divorce occurs, a division of assets and business interests is needed.

Mergers, Acquisitions, and Sales: valuation is necessary to negotiate a merger, acquisition, or sale, so the interested parties can obtain the best fair market price.

Buy-Sell Agreements: this typically involves a transfer of equity between partners or shareholders.

Financing: a business appraisal is required before obtaining a loan, so the banks can validate their investment.

Purchase price allocation: this involves reporting the company’s assets and liabilities to identify tangible and intangible assets.
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Goodwill Impairment

See Also:
Goodwill Accounting Term
Fair Market Value
Asset Market Value vs Asset Book Value

Goodwill Impairment

Goodwill Impairment Definition

Goodwill impairment is goodwill that is now lower in value than at the time of purchase. Goodwill is an intangible asset that sellers are willing to pay for; brand, reputation, a large customer base, strong customer service, and important patents all increase a company’s goodwill. Many contrary factors contribute to impairment of goodwill such as negative publicity from high-ranking company officials, unpopular changes in product line, or a decrease in customer loyalty or brand recognition.

How to Calculate Goodwill Impairment

Goodwill impairment occurs when the goodwill value exceeds the fair value (the estimated value of a company’s assets and liabilities).

Goodwill Impairment Example

Let’s say there is a athletic clothing company called Freeform that has $20,000,000 in annual sales and a reported Goodwill value of $10,000,000 due to an exceptional product, consistent customer service, and a loyal fan base. The following year a larger athletic company called AltaCorp purchases Freeform for $30,000,000 (combining the sales and Goodwill values).

Unfortunately, after the purchase is complete, sales fall 50% the consecutive year because AltaCorp’s CEO has to be removed for disparaging comments made towards his female customers. Furthermore, Adidas unfolds a new campaign tarketing young women and gains a cult following that competes with Freeform’s largest customer base. Because of the drop in sales and the AltaCorp’s reputation, as well as the increase of competition in the marketplace, Freeform’s fair market value drops to $15,000,000. Now, the company is worth less than AltaCorp paid for it, so the Goodwill must be reduced, which reduces the overall Total Assets. This is a significant hit to AltaCorp as Goodwill can represent a large portion of the company’s net worth.

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

Goodwill Impairment Analysis

It is important to note that Goodwill Impairment is relative and can be difficult to calculate; in most cases, it’s in the eye of the buyer. Goodwill should be tested annually against the fair value to manage a buyer or seller’s expectations if the company is undergoing business valuation.

Goodwill impairment gained wider attention in the 21st century after it was discovered that many companies had unrealistically increased their goodwill which resulted in unaccurate valuation of their company. Now, scricter accounting standards exist to monitor and calculate goodwill.

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ROCE (Return on Capital Employed)

See Also:
ROE (Return on Equity)
ROIC (Return on Invested Capital)

ROCE (Return on Capital Employed)

ROCE Definition

ROCE stands for Return on Capital Employed; it is a financial ratio that determines a company’s profitability and the efficiency the capital is applied. A higher ROCE implies a more economical use of capital; the ROCE should be higher than the capital cost. If not, the company is less productive and inadequately building shareholder value.

ROCE Formula

The formula for calculating the ROCE =  EBIT/Capital Employed.

EBIT = Earnings Before Interest and Tax
Capital Employed = Total Assets – Current Liabilities.

Calculating ROCE is a useful means of comparing profits across companies based on the amount of capital. It is insufficient to look at the EBIT alone to determine which company is a better investment. You also have to look at the capital and calculate the ROCE. Many consider ROCE a more reliable formula than ROE for calculating a company’s future earnings because current liabilities and expenses.

(Are you trying to maximize the value of your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

ROCE Example

Look at the table below to see the importance of ROCE in action.

Screen Shot 2016-06-08 at 8.32.42 PM

Both Company A and Company B sell computers. Company A represents the Old Factory model; they are a distribution company that sells business to business. Company B is the New Factory; they are also a distribution company, but they sell on the Internet via credit card. Due to this modern convenience, Company B is able to receive payment within two days instead of the forty-five it takes Company A.

If you were to just consider EBIT, Company A looks like the better investment at 7% return on sales compared to Company B’s 5%; however, with such a large DSO number, Company A is out $6,000,000 more than Company B at any given time. This means Company B needs less capital invested in the company which would result in a higher return on equity (ROE).

Thirty years ago, a similar scenario played out between IBM (Company A) and Dell (Company B). In his college dorm room, Michael Dell started taking credit card sales over the phone and was able to grow a billion dollar company with very little capital.
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ROE (Return on Equity)

See Also:
Return On Equity Example
Return on Asset
Return on Equity Analysis
Financial Leverage
Gross Profit Margin Ratio Analysis
Fixed Asset Turnover Analysis

Return on Equity (ROE)

The return on equity, or ROE, is defined as the amount of profit or net income a company earns per investment dollar. It reveals how much profit a company earns with the money shareholders have invested. The investment dollars differ in that it only accounts for common shareholders. This is often beneficial because it allows companies and investors alike to see what sort of return the voting shareholders are getting, if preferred, and other types of shares that are not counted.

The term can be confusing as it has various aliases. Return on Equity used to be called Return on Common Equity; however, ROCE now refers to Return on Capital Employed. Return on Equity is equivalent to Return on Net Worth (RONW).

Return on Equity Explanation (ROE) 

ROE is a measure of how well a company uses its investment dollars to generate profits; often times, it is more important to a shareholder than return on investment (ROI). It tells common stock investors how effectively their capital is being reinvested. A company with high return on equity (ROE) is more successful in generating cash internally. Investors are always looking for companies with high and growing returns on common equity. However, not all high ROE companies make good investments. The better benchmark is to compare a company’s return on common equity with its industry average. The higher the ratio, the better the company.

(Are you trying to maximize the value of your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

Return on Equity (ROE) Formula

The return on equity formula is as follows:

ROE = Net Income (NI)/ Average Shareholder’s Equity

The Net Income accounts for the full fiscal year (prior to dividends paid to common stock holders and after dividends paid to preferred stock holders).

The average shareholder’s equity is found by combining the beginning common stock for the year, on the balance sheet, and the ending common stock value. These values are then divided by two for the average amount in the year and do not include preferred shares.

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Fair Market Value

See Also:
Adjusted EBITDA
Asset Market Value vs Asset Book Value
Valuation Methods
Goodwill Impairment

Fair Market Value

Defining Fair Market Value

Fair Market Value is the price a specific property, asset, or business would be purchased for in a sale. A company’s fair market value should be an accurate appraisal of its worth.

Calculating Fair Market Value is subject to the following conditions:

  1. Prospective buyers and sellers must be knowledgeable about the asset.
  2. Buyers and sellers must not be coerced or strong-armed into selling or purchasing.
  3. All parties must provide a reasonable time frame for the transaction to be completed.

In other words, FMV is an estimate of the amount of money an industry-educated, interested, unpressured buyer would pay to an industry-educated, interested, unpressured seller.

How to Determine the Fair Market Value of Your Company

If you are considering selling your business in the future or are just trying to strategically plan for the long-term, determining the fair market value of your company is a crucial step. The difference between the fair market value and the purchase price can often be considerable; consequently, many sellers hire professional appraisers for business valuation. This cost can range from a few thousand dollars to $50,000; however, it is highly recommended to hire a third party as most owners inaccurately estimate the value of their business, which can lead to disappointed expectations regarding the company’s value or a low sale that leaves hard-earned money on the table.

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

There are many ways to calculate the Fair Market Value of your business; some of the factors that affect a business’s FMV are the business type, the economic conditions at the desired time of sale, the book value, recent income, dividends, goodwill, and recent prices paid for comparable businesses. During an assessment of your company, an appraiser will look for the following items along with many others:

  1. Future Earnings: An appraiser will forecast future earnings over multiple years, factoring in the discount cash flow and discount residual value by comparing your company to similar ones. The discount rate reflects the diminishing value of money year after year. They will also determine the “capitalization of earnings rate,” which indicates the cost of capital and the company’s risk.
  2. Asset Assessment: They will evaluate the Fair Market Value of all the tangible assets of the company, such as inventory or equipment, as well as the intangible assets, such as brand, reputation, and location.
  3. Comparable Sales Figures: They will analyze recent sales of commensurate companies.
  4. A Partial Purchase Discount: If the buyer is purchasing a minority share of the company, less than 50%, a discount will typically be applied since the other party would still control the business.

Appraisers and valuation experts typically use more than one approach when evaluating the FMV of a company. So grab your business tax returns and general ledger to get started identifying the value of your business today!

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Multiple of Earnings

See Also:
Normalized Earnings
Adjusted EBITDA
EBITDA Definition
Valuation Methods
Business Valuation Purposes

Multiple of Earnings

Multiple of earnings is one way to value a business. It involves multiplying a company’s profits by a certain number to end up with a value. “Multiple of earnings” multiplies the “earnings” (or income or profit) of a year, or average of years, in order to come up with a figure representing the company’s worth in a sale.

In most cases, EBIT (Earnings Before Interest and Taxation) is the amount used for this first earning’s number. However, for companies ranging from several million dollars to several hundred million dollars, the “multiple of earnings” is often equivalent to the multiple of EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortization) instead of EBIT.

Determining what number the current profits are multiplied by depends on the stability of the business. For example, a company that’s very well-established, with a strong hold on the market, that can operate under or with an entirely new team might bring in a multiple of 8 to 10 times current profits. On the other end of the spectrum, a small, individualized business that relies solely on one service provider might acquire a multiple of 1 times current profits. In reality, most businesses are sold for a multiple of 3 to 5 times the current profits.

Using Multiple of Earnings for Business Valuation

There are many different methods for business valuation; however, the central method calculates multiple of earnings. You should consider some of the following questions before evaluating a company:

  1. Is a seller using pre-tax earnings or post-tax earnings? If you’re the buyer, remember to include your tax rate not the seller’s. If you are the one selling, pick which year of earnings to base the valuation on. Many sellers will use the current year’s earnings even if the second half has not occurred yet. Simply multiply the first half of the earnings to project through the year.
  2. Do you use past profits or projected future earnings? Most appraisers recommend using the profits from the last three years to establish more credibility in the sale; however, you can weight the more recent years more heavily, if the profits are increasing each year, to suggest projected income.
  3. Are the current earnings an anomaly or are they consistent? Many owners will sell after a spike in profits, but you should evaluate the business risk by looking at a more thorough review of a business’s earning history.
  4. What’s the business’s climate? How established is the business? Can it run without the current staff or leadership team? Are there competitors moving in that have yet to affect the company’s earnings? Is the economy growing or shrinking? What is the impact of new technologies on the industry?

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

There are many factors to consider when evaluating a company, and many aspects to include when determining the “true” value. Looking at the profits solely will not give you the full picture of a company’s worth.

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Adjusted EBITDA

See Also:
EBITDA Valuation
Calculate EBITDA
Valuation Methods
EBITDA Definition
Multiple of Earnings

Adjusted EBITDA

Adjusted EBITDA is a valuable tool used to analyze businesses for the purposes of valuation and potential acquisition. It is also called Normalized EBITDA as it systematizes cash flow and deducts irregularities and deviations. Adjusted EBITDA is an additive measure used to determine how much cash a company may produce annually and is typically used by security analysts and investors when evaluating a business’s overall income; however, it is important to note business valuation using Adjusted EBITDA is not a Generally Accepted Accounting Principles standard and should not be used out of context as various companies may categorize income and expense divisions differently.

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization and is a meaningful measure of operating performance as it allows businesses and investors to more fully evaluate productivity, efficiency, and return on capital, without factoring in the impact of interest rates, asset base, tax expenses, and other operating costs.

Adjusted EBITDA is a useful way to compare companies across and within an industry. Many consider it a more accurate reflection of the company’s worth as it adjusts for and negates one-time costs such as lawsuits, start-up or development expenses, or professional fees that are not recurring, just to name a few. More importantly, adjusting EBITDA often reflects in a higher sale’s price for the owner.

Adjusted EBITDA Margin Calculation

Adjusting EBITDA measures the operating cash flow using information acquired from income statements. It can be measured annually but is most beneficial when averaged over a three to five year period in order to account and adjust for any anomalies. Generally speaking, a higher normalized EBITDA margin is preferred, and the larger a company’s gross revenue, the more valuable this new measurement will be in a future acquistition.

(Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

Typically, analysts will then normalize or adjust the standard EBITDA by considering other expenses outside the operating budget. Adjusted EBITDA is found by calculating the Net Income, minus Total Other Income (Expense), plus Income Taxes, Depreciation and Amortization, and non-cash charges for stock compensation.

At this point, you are probably curious how to calculate Adjusted EBITDA. The following is a simplified example of how you might begin calculating this formula for your business. Start with EBITDA; then add back value to your company by considering areas of excess and factoring in one-time costs.

Screen Shot 2016-06-08 at 9.24.05 AM

Differences between EBITDA versus Adjusted EBITDA

There are a few key differences between EBITDA and Adjusted EBITDA. EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, idenitifies a company’s financial profits by calculating the Revenue minus Expenses (excluding interest, tax, depreciation and amortization). It compares profitability while excluding the impact of many financial and accounting decisions. The EBITDA margin is an assessment of a company’s operating profitability as a percentage of its total revenue. Calculating the EBITDA margin allows analysts and investors to compare companies of different sizes in different industries because it formulates operating profit as a percentage of revenue.

Adjusted EBITDA, on the other hand, indicates “top line” earnings before deducting interest, tax, depreciation and amortization. It normalizes income, standardizes cash flow, and eliminates abnormalities often making it easier to compare multiple businesses. Redundant assets, owner’s salaries or bonuses, and a facility rental above or below fair market value are all examples of adjustments that would need to be accounted for when evaluating the value of a company for a buyer.

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