Valuation of a business, Part 2

Valuation of a business, Part 2 By TOM McCALLUM, FCGA, CBV This is the second of three articles by Mr. McCallum on Valuation of a business to be carried on PDNet. Introduction Business valuation Approaches and methods Start by measuring tangible asset backing How is TAB used? Liquidation value Going-concern value Introduction The purpose of this series of articles is to acquaint the reader with the basics of business valuation and the information is principally directed to the valuation of a closely-held private corporation, which is the typical business client of a CGA firm. The first part discussed the processes and principles of valuation; Part 2 will look at the application of some of the basic approaches and methods. Business valuation Approaches and methods As mentioned in Part 1 of this series, there are two basic approaches which a valuator can use to determine the value of a business. These are the empirical approach and the investment approach; the latter is the most widely used in valuating a closely-held business or business interest. In the empirical approach, fair market value is best determined by reference to open market transactions involving similar businesses. In the investment approach, fair market value is best determined by reference to detailed investment analysis using the techniques of financial statement analysis and risk measurement theory. Inside the investment approach, there are two methods which are used to value a business: asset basis, and income or cash flow basis. The asset basis is used in either, or both, of a goingconcern or liquidation value approach, while the income/cash flow basis is used only in the going-concern value approach. Which basis applies? You cannot change the value of a business by changing the method you use to measure that value. Value is $x, or $x to $y, no matter how you measure it. Value, and the approach used to measure it, can be determined only after a careful and detailed study and analysis of the business, including the political, economic, and industry environment in which it operates. Your financial analysis of the business usually begins by seeking to answer the question of whether the business is a going-concern, and if it is, whether it has any intangible value (goodwill). If the business is not a going-concern, then the appropriate basis is the liquidation value. However, to answer the going-concern question, we need to first measure the investment in the business. Start by measuring tangible asset backing Tangible asset backing (TAB) is defined as the aggregate fair market value, determined under a going-concern assumption, of all tangible and identifiable intangible assets, where the latter have values that can be separately determined, less all liabilities. Tangible asset

backing (TAB), or at least an initial measurement of it, is determined and used, irrespective of which basis is used. Consequently, it is an excellent starting point. To measure TAB, the valuator must restate the book values on the balance sheet to fair market values. Some valuators will use value-in-use (depreciated replacement value), rather than market values, and some will allow for the unrealized tax shield resulting from the difference between the undepreciated capital cost and depreciated replacement value or realizable value. The arguments, for or against either particular methodology, are beyond the scope of, and what needs to be addressed in, this document. For most valuations of a closelyheld business interest, the market value of the assets is used and the unrealized tax shield is ignored, unless it is material. This approach also fits our present need of using TAB as our starting point. If the net book value of a business was $400,000, and this includes land originally costing $50,000, and a building originally purchased for $150,000, which had been amortized to $125,000, the valuator would make an adjustment to reflect today s market values. Assuming this is the only required market value adjustment, TAB would be determined as: XYZ LIMITED Tangible asset backing Shareholders equity at June 30, 20xx $ 400,000 Add market value of land and building 300,000 Less net book value of land and building (175,000) Tangible asset backing $ 525,000 If the business is a going-concern or has non-operating assets, we may have to refine our measure of TAB further, but for now you can assume it is sufficient. Notice that TAB is really a going-concern concept. It does not consider neither the costs associated with disposing of the assets nor any income tax consequences which might arise from a sale. If realizable (market) value is used and the unrealized tax shield is ignored, the only difference then between TAB and liquidation value is the liquidation costs. How is TAB used? TAB will be used to assist in measuring the risk inherent in the business, measuring whether the business has any intangible (goodwill) value, and in determining the liquidation value of the business. Where the business has no goodwill, but is a going-concern, TAB will be the fair market value of the business. First, let us examine liquidation value. Liquidation value The liquidation value approach has three applications, of which only two are considered here: where a business is not viable as a going-concern and is suitable only for liquidation; and where a business is properly valued as a going-concern but where that value is closely related to the liquidation value of its underlying assets (a real estate holding company could be an example). The third use is where liquidation value is used as an aid to assess risk in a going-concern. This will be reviewed later, under the going-concern valuation section of this document. There are two distinct types of liquidation; the orderly liquidation, and the forced liquidation. Valuation of a business, Part 2 2

How was TAB used? An orderly liquidation assumes that a reasonable period of time is allowed to obtain the highest price for the assets being liquidated. However, caution must be exercised, as costs incurred over this reasonable time might exceed the difference between the price realizable on an orderly liquidation over that available in a forced liquidation. Where such costs will exceed this incremental gain, then it is appropriate to utilize forced liquidation values, as these would provide higher proceeds. A forced liquidation assumes that the assets will be sold within a short time, without any attempt to realize the highest price. This is often referred to as a fire sale. Forced liquidation is irrelevant in any determination of fair market value, except in the cost vs. incremental price impact noted above. Unlike the measurement of tangible asset backing, the measurement of liquidation values does take into account all cost associated with the disposition of the assets (turning them into cash), including the related income tax consequences. The following example illustrates the determination of liquidation value. XYZ LIMITED Liquidation value June 30, 20xx Low High Shareholders equity (per initial measure of TAB) $ 525,000 $ 525,000 Less estimated disposition costs of assets (i.e., realtor, legal, auction fees) 35,000 35,000 $ 490,000 $ 490,000 Less: Provision for uncollectible accounts receivable (10% 20%)* 20,000 10,000 Write down prepaid expenses (20% 50%)* 10,000 4,000 Write down inventory (15% 30%)* 50,000 25,000 Employee termination costs 50,000 25,000 $ 360,000 $ 426,000 Less: Income taxes on assets realization 70,000 50,000 Income taxes on surplus distribution 65,000 56,000 Liquidation value (range) $ 225,000 $ 320,000 * Please note that the percentages are for illustration only and are not intended to be a guideline. The above example illustrates that the higher tax costs are assigned to the lower pre-tax liquidation value. It shows also that a prospective purchaser might be willing to pay more than liquidation value, as given above, for shares in a company in which the sole asset was cash prior to tax on surplus distribution. There are two ways that TAB was used in the liquidation value determination. First, it was the starting point for the asset realization amount from which the liquidation costs were deducted. Second of all, TAB was used to determine whether the business was producing a sufficient return on its net assets to justify a going-concern valuation. Here, it was determined that it was not, and the business was suitable only for liquidation. This could have been concluded from a measure such as comparing the annual maintainable earnings from the business (assume $25,000) as a return on TAB ($525,000). The indicated return of 4.8 percent is not sufficient to consider the business a going-concern. Valuation of a business, Part 2 3

Very important note The concept and measurement of maintainable earnings is discussed later in this article under the review of going-concern valuations. It is important to recognize that the measure of TAB we are using here assumes that all the assets are employed in the business. If that were not true, the rate of return on equity employed in the business would be higher than 4.8 percent, and a liquidation value may not be appropriate due to the existence of assets surplus to the needs of the business. This will be explained further in the section on Redundant assets in Part 3 of this series. Going-concern value Where a business is determined to be a going-concern, there are two possible bases for determining value: asset basis, and earnings/cash flow basis. The choice depends on whether the business has any commercial goodwill. As previously noted, where there is none, the value of the business equals TAB (asset basis of valuation). Goodwill For valuation purposes, goodwill is defined as the excess of going-concern value over tangible asset backing. For example, if the going-concern value of the business is estimated at $400,000 to $500,000 and the TAB is $300,000, then the goodwill is valued at $100,000 to $200,000. Earnings approach There are different kinds of goodwill, but they can be categorized as either commercial or personal. Commercial goodwill is connected with a business and can be transferred to new business owners, consequently, it has transferable value. Personal goodwill is connected with the owner(s) of a business, either through their special skills or their personal contacts and reputation. Personal goodwill may provide excess earnings over those expected with a given tangible asset backing but is not transferable and, consequently, has little or no market value. Accordingly, a key element in any business valuation is to identify the nature of the goodwill and whether or not it has any commercial (transferable) value. This is where some accountants go wrong in providing a business valuation. They assume that because a business has excess earnings over that expected with a given amount of tangible asset backing, the business has value in excess of TAB. This depends on the nature of the business. For example, we can say that there is a goodwill in a criminal law practice or computer consulting service that provides the proprietor with excess income. However, it is almost certain that the goodwill is personal to that business owner and has no commercial value. That is, the goodwill cannot be transferred to another business owner. So, while it has value, what is known as value-to-the-owner, its fair market value is zero. The most common approach to determining the value of a business, where that business has commercially transferable value in excess of TAB, is the capitalization of earnings method. Maintainable earnings are divided by what the valuator determines to be a reasonable rate of return an investor would anticipate, given the nature of the business, and the risks attached to it and its earnings. For instance, if maintainable earnings are $75,000, and a reasonable rate of return is determined to be 25 percent, the value of the business is $300,000. Most frequently, the capitalization rate is expressed as a multiple. The multiple is simply the inverse of the capitalization rate. In the above case, that would be 100 divided by 25, which gives a multiple of four, and 4 $75,000 = $300,000. Valuation of a business, Part 2 4

Maintainable earnings The ultimate calculation is simple, but the determination of the rate of return and the maintainable earnings is difficult. One of the key principles of valuation is that value is prospective. It is equivalent to the present value, or economic worth, of all future benefits anticipated to accrue from ownership. Consequently then, the value of a business, which is based on a capitalization of its earnings, requires a measure of the prospective earnings of the business. These measured future earnings are known as maintainable earnings, which are defined as earnings that are anticipated on a year-in year-out basis, but not necessarily every year, in the foreseeable future. For a relatively mature business, whose product lines/services are unchanging, past earnings may serve as a proxy for future expectations. The past earnings will, however, require adjustments to delete past non-recurring items, unusual events which are not expected to repeat, and discretionary items. The adjustment of past earnings is referred to as normalization. Examples of items requiring adjustment include: management salaries, as these are usually discretionary or driven by tax reasons and/or family situations rather than by the value of the economic input into the business; non-arm s length rents and other expenses; personal expenses; lack of interest charges on debt to related parties; excessive entertainment expenses; excess charitable donations; moving costs; consultants fees; termination benefits; and so on. The list is virtually endless, and an examination of the income statement on a lineby-line basis is essential. It is worth repeating here that past earnings can be relied on only to the extent that they are indicators of what may be expected in the future. With relatively new businesses, or when there has been a recent change in operations, it may be necessary to rely on forecasted earnings. EXAMPLE CO. LTD Maintainable earnings June 30, 2003 2003 2002 2001 2000 1999 Income before income taxes $ 95,000 $ 70,000 $ 55,000 $ 60,000 $ 50,000 Adjustments: Management salaries 1 125,000 100,000 80,000 75,000 65,000 Gain on capital asset 2 8,000 Consultant expense 3 5,000 Interest 4 1,000 3,000 4,000 8,000 9,000 Adjusted income $ 221,000 $ 181,000 $ 139,000 $ 148,000 $ 124,000 1 add back all recorded management salaries (an allowance will be made later) 2 non-operating income 3 one-time, non-recurring expense 4 adjust interest so it reflects rates and debt levels expected to prevail in the foreseeable future In a high inflation rate environment, it would also be necessary to adjust the adjusted income for changes in the Consumer Price Index. In the above example, a non-inflationary, or lowinflationary, environment has been assumed and no changes are required. Valuation of a business, Part 2 5

The above illustrates the process of normalization. The range of years selected for Example Co. Ltd represents a full business cycle for the company. The adjusted income shows that Example Co. Ltd enjoys steady growth. Provisions now have to be made for management salaries and income taxes. The easiest way to do this is on a current basis. This means selecting a range of adjusted income that represents maintainable earnings on a premanagement salaries and pre-income taxes basis. The selected range depends on the circumstances and the valuator s assessment of Example Co. Ltd s future prospects. The range could be composed of a forecast, the most recent year, or a straight or weighted average of some or all of the years. In this case, because of the steady upward growth demonstrated by Example Co. Ltd, a combination of the current year and a weighted average will be used. 2003 - $221,000 5 = $ 1,105,000 2002 - $181,000 4 = 724,000 2001 - $139,000 3 = 417,000 2000 - $148,000 2 = 296,000 1999 - $124,000 1 = 124,000 $ 2,666,000 To determine the weight average, $2,666,000 is divided by 15 (total number of years), and the result is $ 177,733. An appropriate range might therefore be $180,000 to $220,000, which is the weighted average (rounded) as the low and the most current year as the high. From this range, an allowance will be made for management salaries, then income taxes, to determine maintainable earnings. By referring to published data on employee salaries, the valuator finds that for a company of this size in this industry, a reasonable salary for a manager is $75,000. A corporate income tax rate of 20% has also been determined by reference to prevailing tax rates. Maintainable earnings then are: Low High Adjusted income $ 180,000 $ 220,000 Less management salaries 75,000 75,000 $ 105,000 $ 145,000 Less income taxes 21,000 29,000 Maintainable earnings $ 84,000 $ 116,000 Basis of adjusted income/maintainable earnings Forecast Current year Straight average Weighted average May be appropriate when newer company or older company with new products/services 1. drastic change in earnings 2. matured 3. constant upward trend which is expected to continue 4. recent change in product/service inconsistent earnings but overall upward or downward trend stable and a change in earnings/cash flows is unlikely Valuation of a business, Part 2 6

Selection of capitalization rate Some argue that the selection of an appropriate capitalization rate is the most difficult part of the valuation assignment. The author believes that while there is no question it is very difficult, it is no more difficult than measuring the appropriate range of maintainable earnings. That is to say, each is very difficult, and of paramount and equal importance. A material error in either will render the valuation wholly wrong. The astute observer will have noted that the selection of the appropriate range of management salary has the same potential impact but, at least in that instance, there is published information and the valuator is not relying almost exclusively on judgement. The appropriate capitalization rate will be a factor of the following: prevailing rates of return offered on alternative investment opportunities, the political and economic environment, the risk inherent in the business, money and stock market conditions, competitive position of the business and competition in the industry, management depth, types of products/services, contracts, labour force, liquidity, and so on. In the end, the determination is at the judgement of the valuator. Fortunately, risk can somewhat be related by reference to the business itself. By examining the tangible asset backing and the liquidation value of the business, the valuator is able to assess some of the relative risk inherent in the business. Consider the following example. Risk assessment Business A Business B Assumed going-concern value before relating it to TAB and liquidation value $ 400,000 $ 400,000 Tangible asset backing $ 300,000 $ 250,000 Liquidation value $ 200,000 $ 100,000 Going-concern risk ($400 $300, $250) $ 100,000 $ 150,000 Absolute risk ($400 $200, $100) $ 200,000 $ 300,000 Business A has less inherent risk than Business B. Given that the two businesses have the same maintainable earnings, Business A should have more value than Business B. The preliminary assessment, that the same capitalization rate should apply to the given stream of maintainable earnings, is erroneous. Returning to the earnings based valuation of Example Co. Ltd, assuming a capitalization rate of 15% to 18% is appropriate, the fair market value of the business would be determined as: Low High Maintainable earnings $ 84,000 $ 116,000 Capitalized at 15%, 18% 6.67 5.5 Fair market value $ 560,280 $ 638,000 Rounded, say $ 550,000 $ 650,000 It is important to note that the lesser capitalization rate (the higher multiple) is applied to the lower level of the earnings range. This recognizes that there is lesser risk attached to those earnings. As mentioned earlier, valuation is not an exact science. Therefore, it is appropriate to be somewhat inexact in expressing the valuation conclusion; hence, the rounding off. Notice though that the rounding off is not material. It would be inappropriate to round off the Valuation of a business, Part 2 7

Example Co. Ltd results to something like $500,000 to $700,000. You cannot use rounding off to hide shortcomings in the determination of either maintainable earnings or the capitalization rate. J. Thomas McCallum, FCGA, CBV, began his tax career in 1967. He is currently based in Ontario and restricts his practice to business valuation and income tax consulting. He has conducted hundreds of seminars throughout Canada, Barbados, and the United States. Active in the Certified General Accountants Association, Tom is a past president of CGA Ontario. Coming next month, the last article in this three-part series by Mr. McCallum on Business valuation to be carried on PDNet. Valuation of a business, Part 2 8