Mergers & Acquisitions:

Business Valuation

Pricing and Buying a Small Business

Balance Sheet Methods of Business Valuation

By Meir Liraz, CEO, BizMove. Used by permission.

Although a balance sheet formula is sometimes the most accurate means to value a business, it is more common to use an income statement method. Income statement methods are most concerned with the profits or cash flow produced by the business's assets. One of the more frequently used methods is the discounted future cash flow method. This method calls for the future cash flows (before taxes and before debt service) of the business to be calculated using the 4-step formula.

 

Income Statement Methods of Valuation

Four Steps

Step #1

The historical cash flows are a good basis from which to project future cash flows. Cash flows are computed to include the following:

  1. The net profit or loss of the business.

  2. The owner's salary (in excess of an equivalent manager's compensation).

  3. Discretionary Benefits paid to the owner (such as automobile allowance, travel expenses, personal insurance and entertainment).

  4. Interest (unless the buyer will be assuming the interest payment).

  5. Non-Recurring Expenses (such as non-recurring legal fees).

  6. Non-Cash Expenses (such as depreciation and amortization).

  7. Equipment Replacements or Additions. (This figure should be deducted from the other numbers since it represents an expense the buyer will incur in generating future cash flows).

While the future cash flows may be projected out for a number of years, for many small businesses it is not possible to predict very far into the future before the projections become meaningless. Even with somewhat larger and more substantial businesses, it is difficult to project cash flows for more than 5 years.

Step #2

Once the future cash flows have been projected, they must be discounted back to their present value. This is done by selecting a reasonable rate of return or capitalization rate for the buyer's investment. The selected rate of return varies substantially from one business to the next and is largely a function of risk. The lower the risk associated with an investment in a business, the lower the rate of return that is required. The rate of return required is usually in the 20-50% range and, for most businesses, it is in the 30-40% range. The present value of the future cash flows can then be determined by using a financial calculator or a set of present value tables that are available in most book stores. The following example demonstrates how the conversion is made with a 40% rate of return.

Year Projected  Discount Present
Cash Flow          Factor *           Value

Year 1 $360 .714                     $257

Year 2 $383 .510                     $195

Year 3 $397 .364                     $145

Year 4 $413 .260                      $107

Year 5 $438 .186                      $ 81
                                              _____
                                               $785 Total**

* - Based on 40% rate of return. The discount factor declines in each succeeding year.

* * - Present value of the sum of discounted projected cash flows. This figure is added to the residual value of the business to arrive at the total value of the business.

Step #3

One more calculation must now be done the residual value of the business. The residual value is the present value of the business's estimated net worth at the end of the period of projected cash flows (in this example, at the end of five years). This is calculated by adding the current net worth of the business and future annual additions to the net worth. The annual additions are defined as the sum of each year's after-tax earnings, assuming no dividends are paid to stockholders. These additions are added to the current net worth, and that total is discounted to its present value to yield the residual value.

Step #4

The residual value is added to the present value sum of the projected future cash flows previously computed to arrive at a price for the business. An example follows.

After Tax Income

Year 1 $125

Year 2 $131

Year 3 $138

Year 4 $144

Year 5 $152

                                       ______       

Total Additions to net worth  $690

Current net worth                 $910

                                      ______

Total net worth                   $1600

Residual Value (1600 x.186) $298* * *

*** - Multiplying the total net worth by the discount factor used in the final year of projected cash flows yields the residual value. Adding the residual value of $298 to the present value sum of projected cash flows of $785 yields a value for the business of $1,083.

Although this formula is widely used, it cannot be applied in this simplistic form to arrive at a definitive value conclusion. It fails to address issues such as the buyer's working capital investment, the terms of the transaction, or the valuing of assets like real estate which may not be needed to produce the projected cash flows. However, it is useful in establishing a price range for negotiation purposes.

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