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Business valuations are an art, not a science. Many individuals prepare
valuations relying on standard calculations, without a true understanding
of the development critical valuation assumptions. Without this understanding
of the valuation assumptions, the valuation calculations are likely to result
in wild ranging amounts that may not reasonably relate to fair market value.
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Primary Valuation Considerations
- Purpose of the valuation, including any legal or tax requirements, type of
entity being valued, date of value needed and definition of the value to
be used (fair value, liquidation value, etc.).
- Type of ownership interest valued - controlling interest, minority interest, etc.
- Industry factors - specific common characteristics of the business' industry.
- Competition's effect on the business.
- Degree of financial risk and leverage of companies in the industry.
- Historical and expected profitability, special revenue or cost trends.
- Growth and development trends.
- Effects of current and expected economic conditions on the industry.
- Company-specific factors.
- Financial condition, including condition of any vital assets.
- Earnings and growth history and trends, including unusual or non-recurring
factors that should not repeat or effect new owners.
- Competitive strengths, depth and quality of management.
- Dependence on key managers, customers or suppliers.
- Litigation, environmental or other contingencies.
- Owner compensation, benefits and spending "style."
- Sales of any comparative companies, prior ownership transactions for this company,
existence of a buy-sell agreement with an agreed or formula value.
Valuation Example - Capitalization of Excess Earnings Methods
- Determine tangible asset value by finding if any equipment or real
estate has been appraised, analyze which assets are intangible assets,
and adjust, if necessary, the business’s net book value for these
appraised values in excess of / less than book values and reduced for
intangible assets.
- Determine normalized historical earnings by reviewing the last five
years’ net income, adjusting income for income taxes and any unusual and
non-recurring items. Attempt to arrive at an adjusted net income that
represents a reasonable expectation of future net income. If a majority
ownership interest or the entire business is being valued, further adjust
net income for owners’ discretionary expenses that a new owner would not
be expected to incur.
- Determine an expected rate of return on the tangible assets, expressed
as a percentage. This return would approximate a return an investor in the
tangible assets would expect to receive strictly from the utilization of
these net tangible assets.
- Determine a capitalization rate to apply to the business’s excess earnings,
considering market return rates, an expected long-term growth rate, and a specific
risk rate for the business.
- Multiply the tangible asset value times the expected rate of return on
tangible assets, and subtract the result from the normalized net earnings to
arrive at excess earnings.
- Multiply the excess earnings times the inverse of the capitalization rate
to get the intangible asset value, and add the result to the net tangible asset
value to get a gross business equity value.
- Apply a marketability discount, if applicable, to get a net closely-held
business equity value.
- Apply a minority discount, if applicable, to the net closely-held business
equity value to get a minority ownership interest value.
- Divide the resulting value by the number of ownership shares or units
outstanding to get a value per minority share.
Capitalization of Excess Earnings –
Example for Valuation of Minority Share
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Estimated fair market value of net tangible
assets |
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$ 400,000 |
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Estimated average normalized net income |
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$ 100,000 |
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Estimated value of net tangible assets |
$ 400,000 |
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Estimated % return on tangible assets |
10% |
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Expected return on tangible assets |
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40,000 |
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Excess earnings |
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60,000 |
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Capitalization rate - 25%, inverse equals a
multiplier of |
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x 4 |
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Estimated value of intangible assets and
goodwill |
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240,000 |
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Estimated gross business marketable equity
value |
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$ 640,000 |
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Estimated discount for lack of marketability
- 30% |
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- 192.000 |
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Estimated closely-held business equity value |
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$ 448,000 |
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Estimated discount for minority interest -
20% |
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- 90,000 |
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Estimated closely-held business minority
ownership equity value |
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$ 358,000 |
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Number of shares of common stock outstanding |
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/ 1,000 |
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Estimated value per minority share |
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358 |
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