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Fair Market Value

Fair Market Value Definition

The Fair Market Value definition 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 to complete the transaction.

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

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, we highly recommend 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“.)

What Your Appraiser Will Look For

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%, apply a discount 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 start identifying the value of your business today by grabbing your business tax returns and general ledger. Before you start the valuation process, download the Top 10 Destroyers of Value to identify any destroyers of value and maximize the potential value.

Fair Market Value

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Fair Market Value

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

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Multiple of Earnings

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

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:

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.

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.

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.

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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Multiple of earnings

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Multiple of earnings

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Adjusted EBITDA

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 because it systematizes cash flow and deducts irregularities and deviations. Use adjusted EBITDA as an additive measure 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. Measure it annually. But when you average it over a three to five year period in order to account and adjust for any anomalies, it is most beneficial. 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 acquisition.

(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

EBITDA and Adjusted EBITDA have a few key differences. EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, identifies 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. Examples of when you need to account adjustments while evaluating the value of a company for a buyer include:

Download the Top 10 Destroyers of Value to maximize the value of your company. Don’t let the destroyers take money from you!

Adjusted EBITDA

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Adjusted EBITDA

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

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PEST Analysis

See Also:

SWOT Analysis
Porter’s 5 Forces of Competition

PEST Analysis

Certain changes to the business environment can either help you or hurt you. Using the PEST Analysis, you can anticipate factors that can be used to your advantage or that you can solve before they affect your company negatively.

Political Factors: Government policies regulate trade markets and other business environments. Political factors such as trade and safety regulations, taxes, and employment all affect a business.

Economic Factors: Factors such as interest rates, stability, taxes, and inflation affect a company’s activity. Following economic trends is important for the company because without preparation, a company may be unprepared for the sudden changes.

Socio-Cultural Factors: By examining the socio-cultural aspects of the environment, you can study the market’s customer demographic, lifestyle choices, disputes or limitations, and general knowledge. Use this to model campaigns and strategies to appeal to the customers within that environment. Education is also a major socio-cultural factor because it molds the mindset of attitude of millennials.

Technological Factors: Changes in technology provide windows of opportunity. With updated technological processes, a company is more prone to innovation, growth of a company, and may even be able to re-target to the younger generation. Technology is always changing, and therefore a company should project how and when to adapt to the change.

PEST Analysis

PEST vs. PESTEL

Some may encourage that the additional “-EL” is necessary to include in this analysis. For this wiki, we will use the term “PEST.” However, if you were curious, the “E” in “PESTEL” stands for Environment and how a company affects it. This means climate, pollution/recycling, and laws surrounding energy usage.  The “L” stands for Legal, which deals with factors such as the laws pertaining to business (employment and safety, patents, discrimination, etc).

How to do a PEST Analysis

Similar to the SWOT Analysis, you should gather all related data pertaining to your environment (political, economic, socio-cultural, and technological). Then, you determine which of the factors serve as an opportunity and which factors are a threat to the company. Keep in mind that this analysis is a decision-making approach, and do not take any action until you have completed the planning. Once you’ve gathered all relevant data and determine the opportunities/threats, the company is then ready to make a change or decision. Download the free External Analysis whitepaper to overcome obstacles and be prepared to react to external forces.

PEST Analysis

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PEST Analysis

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Collection Effectiveness Index (CEI)

See Also:

CEI vs. DSO
Key Performance Indicators (KPI’s)
How Does a CFO Bring Value to a Company?
5 Stages of Business Grief

Collection Effectiveness Index (CEI)

The Collection Effective Index, also known as CEI, is a calculation of a company’s ability to retrieve their accounts receivable from customers. CEI measures the amount collected during a time period to the amount of receivables in the same time period. In comparison, the collection effectiveness index is slightly more accurate than daily sales outstanding (DSO) because of the time period. A company’s CEI can be calculated for any amount of time, small or large. Conversely, DSO is less accurate with shorter time periods, which is why DSO is calculated every 3 to 6 months.

The Collection Effectiveness Index Formula:

Collection Effectiveness Index

The formula consists of the sum of beginning receivables and monthly credit sales, less ending total receivables. Then, divide that by the sum of beginning receivables and monthly credit sales, less ending current receivables. The value is then multiplied by 100 to get a percentage, and if a CEI percentage is close to or equals to 100%, then that means that the collection of accounts receivables from customers was most effective.

(Are you look for more ways to improve your cash flow? Click here for the free complete checklist guide to improve your cash flow!)

CEI and Your Business

The collection effectiveness index is one of the most useful tools a company can use to monitor the business financials. It measures the speed of converting accounts receivables to closed accounts, which then indicates new methods or procedures one can use to retrieve accounts receivables even more. If the CEI percentage decreases, then that’s a key performance indicator that the company needs to put in place in policies or investigate the departments in more detail.

How to Increase a Company’s CEI

Among other ways to reduce accounts receivable, the collection effectiveness index alerts when and how to change the process of retrieving those accounts. By monitoring cash in a company more frequently, financial leaders will notice a pattern and are more inclined to make a change quicker. Changing your policy from checking 3 times a year to 6 or 8 times a year, and the results that come from it, will show a substantial difference in a company.

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Collection Effectiveness Index

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Normalized Earnings

Normalized Earnings

Normalized Earnings are adjustments made to the income statement in preparation to show potential buyers of the company. When making these adjustments, eliminate expenses not usually incurred for the production of the business. To show a more realistic return on investment, the normalized expenses should not appear on the future buyer’s income statement.

Different Types of Normalized Earnings

There are multiple types of special expenses that are unusual on a typical income statement. For now, let’s categorize them into two types of normalized earnings – Type A and Type B.

Type A: Non-Recurring Gains and/or Losses

The goal of “normalizing earnings” is to provide prospective buyers a typical income statement so they know what to expect. Expenses such as a lawsuit, non-operating assets, and other abnormal items that occur once are considered expenses you can eliminate when normalizing earnings.

Type B: Discretionary Expenses

Do not record certain expenses at fair market value price. Adjust these expenses so the buyer of a company does not assume these expenses incur regularly. If you include these expenses, then as the current company owners, you should specify that these expenses or earnings are not generating/generated by business. Examples include vacation homes, car rentals, start-up costs, and unreasonably high bonuses.

(If you want to learn how to measure your company’s key performance indicators for free, then get it here!)

Normalized Earnings Example

For example, Laura Johnson is the CEO and founder of X company, and now wants to sell it. Her current business generated over $2 million last year, according to her income statement.

Normalized Earnings

Type A: Laura experienced a lawsuit and lost $250,000. Because this was one-time event, remove the lawsuit expense for adjustment purposes.

Type B: Laura’s sales team had a sales contest to boost revenue for the year 15%. As a result, two salespeople gained extremely high bonuses totaling to a $100,000 additional salary.

By normalizing these earnings, EBITDA increases by $350,000, earnings that the buyer can potentially make without those extra costs.

SCFO- Lead Magnet for KPI Discovery Cheatsheet

See Also:

Key Performance Indicators (KPI’s)
Collection Effectiveness Index (CEI)
How Does a CFO Bring Value to a Company?

Multiple of Earnings

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Continuous Accounting: The New Age of Accounting

See Also:

Reducing Your Cash Conversion Cycle
Key Performance Indicators (KPI’s)
Accounting Principles 1, 2, and 3
Accounting Principles 5, 6, and 7

Continuous Accounting: The New Age of Accounting

Continuous Accounting is the new age of accounting. It provides a more efficient way to review financial performance in a real-time automated process, and a trustworthy, repeatable accounting cycle to forecast future results. It also gives the financial department a larger role in strategy and planning.

The Old Model: Record-to-Report (R2R) Accounting

The traditional model consists of a linear record-to-report process for accounting. In order to complete a record keeping process, a company must report certain tasks and responsibilities pertaining to the company’s financials. Expect these to be completed by the end of the period – which can last anywhere from two weeks to two months. Store and manage the data in a large computer processor. Disadvantages of this process include:

  1. The data accumulated over a large period of time have a greater chance for error with unreconciled transactions
  2. Inaccuracy and misrepresentation
  3. Takes up too much time and loses effectiveness of team

The New ModelFinancial Strategies with Cloud-Based Technology

Managers and financial leaders cannot afford to wait a month to two months for reports to be processed. This is what bookkeepers tend to do. Continuous accounting changes the prolonging process from period-end to a day-to-day basis. The cloud platform is capable of recognizing and verifying information constantly and repeatedly, thus enabling it to be “continuous.”  This evenly distributes work rather than accumulating large amounts of tasks over time. Continuous accounting is an organized alternative to the old model of record-to-report accounting.

Shifting Business to the Continuous Accounting Platform

In the past, bookkeepers would record with accumulated reports, which would process a month at a time at least. With the matching principle, the company matches the expenses that are incurred during the same period the revenue is recognized (or the time the service was performed). Instead of recording in batches, modify the accounting system record as they occurred. Now, the next progression is to continuously reconcile accounts and analyze detail. In order to do this, have companies automate their systems. Otherwise, bank statements and other records would have to be linked and reconciled daily.

The New Age of Accounting

Advantages of Continuous Accounting

1. Continuous Accounting processes financial information faster than before.

Certain companies depend on a faster cash conversion cycle, in which case this technology would be useful. Instead of reviewing financial information every month or so, continuous accounting will complete the processes day-by-day. The processing of financial information will be quicker, and key performance indicators will become more apparent and easier to fix. This allows financial leaders to eliminate risk and take action proactively and defensively.

2. Automated systems improve the productivity of the accounting departments.

Increased automation should result in the benefit of improved productivity. This reduces costs because taking the manual systems, rather than automatically through continuous accounting, and applying them everyday would be cost-prohibitive.

(Want free access to a tool that can measure your unit economics? Get it here!)

Disadvantages of Continuous Accounting

1. Adapting the finance departments to a new way of accounting.

Implementing change is always a challenge, especially when a department, trained for 10, 20, 3o years on how to properly perform accounting, does it. Larger companies would benefit from continuous accounting more than smaller companies, where new, younger, more adaptable people work. However, the disadvantage of switching from traditional accounting to this new automated technology is that the larger companies have employees that have worked as an accountant for 25+ years and aren’t as adaptable.

2. Financial statements may not be as accurate. 

Instead of waiting a couple of weeks before submitting invoices or reports, continuous accounting processes the information right away. This leaves little time to adjust and organize data. By using continuous accounting, the financial leader succumbs to having financial statements 90% accurate rather than the expected 100%.

How Continuous Accounting Affects the Future of Finance

Technology itself is changing finance departments globally. Continuous Accounting is just the start of new automation processes that pertain to large sources of data. Technology such as Continuous Accounting establishes a precedent for timely, cost-effective, and/or high-quality improvements for business.

Know Your Economics (on blog)-2

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