Everyone knows how to value a company. It is simple. You just take earnings and multiply them by the multiple.
Value = Earnings x Multiple
I call this equation the basic valuation equation. We will see where it comes from and something about what it means shortly, but what seems basic and simple may not always be so…
Business Valuation is [Not] Easy
If valuation is so easy, why has business appraisal become such a niche industry? And why do business owners often misjudge the values of their businesses? And why do most advisers to businesses know so little about the values of their clients’ businesses? We will think about these questions as we proceed.
Many years ago, a bank supervisor was fond of saying to her charges when she was assigning new projects, “All you have to do is…” A friend told me that whenever Nancy said “All you have to do…” you knew that there was a lot in handling the project.
And so, there can be a lot to determine Earnings. After all, which Earnings are we talking about? There are a number of earnings concepts, including: pre-tax earnings, operating income, net income, and EBITDA. So what is EBITDA?
We will talk about EBITDA and other income concepts as we progress. For those who can’t wait, it is Earnings Before Interest, Taxes, Depreciation and Amortization – or EBITDA for short.
And there can be a lot to do to determine the Multiple. For starters, we have to match the selected Multiple with the kind of Earnings that are appropriate. For example, it would not be appropriate to apply a price-earnings multiple of 10.0x applicable to the net income (an after-tax measure) of a public company to the EBITDA (a pre-tax earnings measure) of a private company.
It has been said that business valuation is part art and part science. This statement is true. How do business appraisers, who are first and foremost scientists with respect to the discipline of valuation, at least initially, learn the art part of the equation? They do so from experience and from having their valuations tested by comparison with real world transactions.
What is even scarier is that sometimes, third parties – and that might be you! – have to rely on the conclusions of business appraisers when engaging in transactions in private company stock. If that is the case, you want your appraiser to be a scientist and an artist.
The kind of value determined by our equation (Value = Earnings x Multiple) is often that of fair market value. Revenue Ruling 59-60 provides a definition of a standard of value known as fair market value.
We will talk about fair market value shortly, but RR 59-60 tells appraisers that they should apply their art and science in the context of exercising three critical factors – common sense, informed judgment, and reasonableness. Conceptually, we can view business value (and fair market value) as in the following figure.
The five concepts in the chart above provide tension for appraisers who attempt to determine fair market value. Science is fine, but it must be supplemented by the Art side. Things are not always what they seem to be.
Science and Art can be combined in the exercise of Informed Judgment. Perhaps Informed Judgment is defined by this combination.
However, Common Sense is important in fair market value determinations. What if the initial conclusion based on Art and Science defies Common Sense? Remember what Frank Lloyd Wright said in another context:
There is nothing so uncommon as common sense.
And then, finally, fair market value conclusions must be tested for their Reasonableness. Is the result reasonable in light of market external evidence. Is is internally consistent based on all of the facts and circumstances of a business situation?
We’ve talked about fair market value somewhat generally, so now, let’s get specific. We need to do this because, as we will see, companies are not sold at their fair market values. Ideally, they are sold at the best prices available in their markets at the time they are on the market – at least from the viewpoint of sellers. But we begin with fair market value.
Fair Market Value for Business Owners
Fair market value is a special kind of value. It is important to business owners because it is the kind of value that is applicable for many private company transactions, including:
- Gift and estate tax planning. All appraisals done for gifting or estate planning purposes are required to be performed under the standard of fair market value.
- Buy-sell agreements. There is no requirement that owners use fair market value as the basis for pricing their buy-sell agreements, but it is well-known and well-understood. For a thorough discussion of buy-sell agreements (and fair market value), click to read my Kindle book, Buy-Sell Agreements for Baby Boomer Business Owners, available on Amazon.
- Valuation in divorce. Hopefully no business owner readers of this book will be involved in a divorce, but the standard of value in divorce valuation in many states is fair market value.
- Charitable donations. Charitable donations of business interests are required to be supported by fair market value appraisals. Note that there is tension for business owners who may desire low valuations for estate tax planning purposes and high valuations for charitable gifting purposes. However, if the interest is the same, then the fair market value is the same for both purposes.
- Support for value of stock as collateral for loans. Often, financial institutions will require businesses to obtain appraisals of the fair market value of their shares to provide comfort and documentation for lending institutions.
The point is that if a business is around for a long time and if it achieves a significant value, the owners will be required (or find desirable) to obtain appraisals of the fair market value of their companies (or interests in them) in the normal course of business.
What is Fair Market Value?
Fair market value is defined in Revenue Ruling 59-60. It is also defined in the ASA Business Valuation Standards published by the American Society of Appraisers.
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Fair market value has been called an “arm’s length” kind of value. Buyers and sellers are willing and able to transact and are assumed to negotiate in their own best interests. These buyers and sellers are hypothetical parties.
The parties are negotiating from investment viewpoints only, and are under no compulsion (financial, emotional or other) to engage in a transaction. The buyers and sellers are assumed to have reasonable knowledge about the subject business interest. The market for the interest, while not public in the case of private companies, is unrestricted in terms of transfer.
Going a bit further, fair market value assumes that a hypothetical transaction occurs on what is called the valuation date on a cash or cash-equivalent basis.
We can see that fair market value occurs at the intersection of negotiations between hypothetical willing buyers and sellers.
Why are we talking so much about fair market value in a primer for business owners on business valuation? Because this standard of value is well-known, is used for most private company transactions, and is known and understood (hopefully) by business appraisers, judges, and others who might be involved with private company transactions.
In the next post, we will talk about the basic valuation equation and see what it can tell us about private company business valuation.
In the meantime, be well,
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