Part 2: Understanding Your Business Valuation – The Price is Right. Right?
By Ashley DeCress, CPA, ABV, CVA, Manager, Advisory Services
Let’s say you go to the store to pick up a carton of eggs and a few other groceries. Once you reach the self-checkout and start scanning your items, you notice your eggs cost $2 more than you expected. I know – an additional $2 doesn’t mean much in the grand scheme of things and you might shake off the extra expense and continue with your check out. BUT, there is a reason for that price and factors that went into its determination. Maybe the eggs were from free-range chickens, or they were pasture-raised, or maybe someone even slipped a golden egg in there. The point is, you won’t know until you understand those key details.
Odds are that if you have chosen to learn about the value of your business, you care more about your business valuation than the pricing of a carton of eggs. So if you receive a valuation for your company, you should make sure you understand all of the pieces and parts that are incorporated into that value.
To begin your valuation, it is necessary to accurately depict the purpose (strategic planning, potential transaction, estate or gift tax purposes, etc.), the standard of value (fair market value, fair value, investment value, etc.), the level of value (control, marketability and voting basis) and the premise of value (going concern, liquidation, etc.).1
After these details are nailed down, it’s time to deep dive into the general company information and financial analysis, including the following:
Historical Financials and Company Information
The valuator typically reviews five years of financial statements (preferably CPA-prepared) and/ or tax returns, summarized by year, to understand trends and growth. After this initial review, the valuation professional gathers questions to better understand the company’s history and operations, as well as the financial data. A management interview is held to discuss the questions and provide any additional information that may be important in determining the value of the business. The information is used in generating the normalized financial statements.
Based on the information provided in the management interview and review of the financial information, certain normalizing adjustments are made to the company’s historical financial statements. Normalizing adjustments are necessary to remove the effect of certain standard accounting principles that may contradict or imperfectly reflect economic reality. Moreover, normalizing adjustments eliminate any discretionary, non-operating or non-recurring items that may distort the reported results of operations or financial position of the company as of the valuation date.
- Discretionary Items – These items are at the discretion of the owners and include personal (non-business) expenses for the benefit of the owners. Typical discretionary expenses include owner or family compensation (if not at fair market value rates for services provided), officer life insurance, personal travel or vehicles, personal meals and entertainment expenses, social club memberships, etc. To qualify as discretionary, the expense must benefit the owner(s), not benefit the business or its employees, and be expensed by the business (included as expense on the company’s tax returns and financial statements).2
- Non-Recurring Items – Non-recurring items are income or expenses that are one-time in nature and not expected to occur regularly. These items are considered to be infrequent or unusual and may include litigation fees, bad debts, repair costs following an accident or natural disaster, etc.
- Non-Operating Income and Expense – Non-operating income and expense items are incurred from activities unrelated to the core operations of the business. Non-operating income may include interest or dividend income, gains on sale of assets, profits from investments, etc. Non-operating expenses include interest expense, depreciation and amortization, losses on sale of assets, etc.
- Non-Operating Assets – Non-operating assets are not necessary to the normal ongoing operations of the business. These assets may include marketable securities, loans receivable, personal assets, real estate, etc.
Normalizing adjustments may also be made for fluctuations in the company’s benefit stream. For example, repairs and maintenance expenses may increase or decrease dramatically from year to year. These expenses can be smoothed over the years analyzed to create a normalized benefit stream.
During the management interview, information will be provided about the company’s operations and history, key customers and vendors, competition, and the company’s industry. In the valuation of any entity, it is important to gain an understanding of the industry in which the entity operates, including composition, trends, and opportunities or potential threats posed to the company.
Resources are compiled and analyzed to determine the positive and negative industry factors, key ratios for similar companies, and expected growth. The documented factors are taken into consideration in the determination of the specific company risk, industry risk factor (beta) and the company’s long-term growth rate.
Gaining an understanding of the economic climate in which the entity operates is also essential to developing reasonable expectations about the future economic impact on the company as of the valuation date. An important factor considered today is the impact of the coronavirus pandemic and the effects of the economic shutdown. The positive and negative factors determined in the economic outlook are considered in developing the specific company risk rate and long-term growth rate of the company.
All of the above information is factored into the value of the business through the application of the various valuation methodologies (asset- and income-based approaches) and is then adjusted for discounts based on the level of value (control, marketability and voting basis) determined.3 If an owner takes the time to understand these factors and their impact, inaccuracies in information or potential changes may be discovered that could lead to changes in the valuation. Knowledge of the process, valuation metrics, and key data also allows the owner to continue growing the business value and best position the company for a sale.
- For more detail about these topics see the ‘Understanding Your Business Valuation – First Steps’ article.
- Depending on the approach employed by your valuation professional and the level of value being determined, discretionary normalizing adjustments may not be made when valuing non-controlling ownership interests. It is common for valuators to forgo these adjustments as a non-controlling owner does not have the ability to change the company’s behavior relative to these items.
- For more detail about the approaches and discounts see part 3 of the blog series, ‘Understanding Your Business Valuation – Approaches and Discounts’ article.