Valuing a Business

I. The Income Approach Projected Cash Flow x Capitalization Rate = Value Based on Future Income Case Study: Let's assume you own Beads & Baubles, a small retail jewelry operation. We'll say that the business has projected 2007 sales of $500,000. To find the fair market value, it is then necessary to divide that figure by the capitalization rate. Therefore, the income approach for this company would reveal the following calculations: Projected Sales Capitalization Rate Fair Market Value $500,000 25% $125,000

As the figures show, a reasonable value for Beads & Baubles would be $125,000. A. The Multiple of Earnings Approach As an example, if you were considering the purchase of a fictitious mid-sized children's clothing manufacturing company called Strawberry Patch Inc., and their 2007 earnings before interest and taxes was $1.5 million, you could reasonably expect the fair market value of the firm to be between $7.5 million and $10.5 million (using a multiple between 5 and 7). Calculations: $1,500,000 x (5) = $7,500,000 $1,500,000 x (6) = $9,000,000 $1,500,000 x (7) = $10,500,000 II. The Asset Approach Tangible Assets + Intangible Assets (Goodwill) = Asset Value Case Study: Let's revisit our example of Beads & Baubles and conduct an asset evaluation to make sure that the value arrived at using the income approach ($125,000) is greater than the value of the assets owned by the business. If it is not, the asset approach would be more appropriate in determining the value of this company and its profit would not justify the business's investment in the assets it owns. Assume that the company's assets are valued as follows: Equipment Furniture Inventory Goodwill Fair Market Value of Assets $12,000 $7,000 $25,000 $15,000 $59,000

In this case, since the asset value derived is lower ($59,000), it would be more appropriate to follow the income approach to valuation.

III. The Market Approach Self-Assessment: Ask yourself the following when seeking potential comparative companies: 1. 2. 3. 4. 5. 6. 7. 8. Has the company been in business the same amount of time? Does it have similar known risk factors? Are the levels of profitability similar? How about other financial ratios are they relevant to my target business? Are past and future growth patterns comparable? Is there a similar competitive landscape? Does the firm have a parallel customer base? How alike are the key technologies used in the two businesses?

If you cannot find similar public companies that have recently sold, you can use a variation of this approach to compare the stock value of similar publicly traded companies to their estimated book value. You can then divide the respective stock values by their book values to derive a market-valueto-book-value multiple. This multiple represents the premium over book value investors place on such companies. This multiple can then be applied to your company's book value. Company A: $53 (stock price) = 5.88 (multiple) $900,000 (book value) Company B: $89 (stock price) = 5.93 (multiple) $1,500,000 (book value) Average Multiple = 5.9 In this case, multiplying 5.9 by your target company's book value would yield the fair market value under the market approach.