Educating Business Owners On Valuation Methods

By Author: Mary Rose Somera
Total Articles: 94
Comment this article

Business owners usually need to get their company valued. It may be done for estate tax planning, the purchase of shares by a co-owner, or to be included in a financial statement. Sometimes it is done for a specific reason, such as for post-sale retirement planning. Whatever the cause, there are numerous methods for valuing a firm other than through an actual sale.

Here’s a discussion of the different approaches of valuing a firm. The majority of requirements fall under the purview of financial planning, and this article offers guidance to CPA personal financial experts on how to approach business owners regarding the valuation process and its workings in advance. This post won’t go into detail on how to compute the value because that is something that should be left to a qualified expert.

The Initial Point

The true value of the company’s tangible assets and net income must be ascertained before any valuation can be carried out. Projected net income can also be required in specific circumstances. The most current financial statement serves as the starting point in each scenario.

Amounts for ...
... assets, such as machinery, that are over- or undervalued based on replacement cost must be adjusted after starting with book value. The initial cost’s unamortized value is reflected in the book value. The difference between the machinery’s current value and its book value is either added to the book value or deducted, depending on which is greater. If there are any liabilities that are not disclosed or contingent, such as loans to owners, book value should be increased by those sums. If there are any liabilities that will not be paid, however, book value should be decreased by those sums. It may not always be simple to calculate the worth of equipment; in these situations, if it is important to the entire valuation, it is required to hire an appraiser. Otherwise, the owner should be able to provide straightforward estimates.

Foundation for Valuation

The two probable presumptions for a valuation are either that the company will remain operational as-is or that it will be liquidated. For most valuations of a profitable business, the liquidation alternative should not be considered unless the assets are substantially underutilized and by themselves have values greatly in excess of what the business could be sold for based on its earnings. Typically, this is not decided until the valuation process is complete.

Operating Revenue

It is important to make changes to the business’s net income in order to normalize the earnings based on what they would be if the business were owned or run in a more typical or suitable way. An illustration would be if the owners received salaries that were significantly higher than what an employee performing the same tasks would earn. Other adjustments could be made for above-market rent paid to an owner who also serves as the landlord, fringe benefits that are above what would be considered typical for that type of business, advertising, marketing, or public relations costs incurred out of ego, moving, restructuring, legal, or special consultant costs that were one-time events and won’t reoccur, or personal expenses that a new owner would eliminate. As a result, net income is “normalized,” which serves as the foundation for any valuation. Since some adjustments may point to improper compliance with income tax reporting, people should be educated about the normalization of income procedure.

Valuation Objective

The valuation is ultimately an opinion based on specific facts and assumptions, even if official valuation papers might be more than 50 pages long and include several calculations. Additionally, depending on the valuation’s objective, many various values may emerge, thus it is important to be clear about this before starting. Although many people associate these two problems together, valuing a firm for inheritance tax reporting purposes differs from doing so for gift tax purposes. Furthermore, valuing a corporation for divorce purposes would be done entirely differently from valuing it for executive remuneration or, for that matter, for a sale to a buyer who wants to work in the company. For a partner’s buyout upon death and perhaps for that same partner’s retirement, another procedure would be used.

The standard of value that is applied and, in turn, the basis of the valuation are both influenced by the aim of the valuation. The fair market value criterion is used in divorce valuations as well as gift and estate tax valuations. The fair value used for divorce is also distinct from the fair value used to evaluate assets on an audited balance sheet. Similar to this, when a C corporation transforms to a S corporation, built-in gains are valued differently than employee stock options. The divorce standard is determined by the state in which it is finalized. Finding the right standard requires patience.

Inferences Needed

A valuation requires a lot of assumptions. As mentioned above, a number of assumptions will have been made in order to calculate the normalized net income. After determining the normalized net income, the owner must choose whether to look at the earnings in the past or the future. Fair market values frequently call for some form of average of prior years’ earnings. Depending on the situation, it could be the past two, three, four, or five years without taking into consideration predicted earnings for the current year (which would also be an assumption). Another presumption is choosing between a mean average and a weighted average. If predicted earnings are to be used, additional assumptions must be made, and those reports may need to be submitted by the customer or completed as a separate contract.

Discount and capitalization rates are two further hypotheses. A capitalization rate is required to calculate value based on the buyer’s or acquirer’s predicted earnings, whereas a discount rate is utilized to calculate the present value of future earnings used in the valuation. For instance, to calculate the value of a business, the normalized net income should be divided by the expected rate of return on investment, in this case, 15%. Thus, a lower value will result from a higher capitalization rate, and vice versa. A capitalization rate can be calculated using a variety of factors, each of which is an assumption.

Adjustments for minority or swing vote interests as well as the marketability of minority or non-controlling interests are included in fair market value business appraisals. Both the choice to apply such modifications and the changes themselves are assumptions.

Supplemental Information

No appraisal can be performed without knowledge of the company’s organizational structure and operational processes, including its capital structure, ownership, employment, customer and supplier contracts, leases, sales generation, competition, key employees, special formulas, brand equity, warranty obligations, special customer or supplier relationships, industry situation and market share, competitive and disruptive pressures, and many other elements that are unique to the company. Along with the financial accounts and statistics, an appraiser must also examine all of them.

Value Determination

An estimated value can be established when all the data has been gathered, reviewed, investigated, and evaluated, assumptions have been used, and data has been structured and tabulated. This is only a guide to the value in the absence of a real sale. Given the number of assumptions involved, it would be inaccurate to refer to it as a “informed recommendation,” but it does represent a best-case valuation.

Reports on Valuations

Two distinct value reports are available from CPAs. Of all the valuations created by CPAs, a conclusion of value is an official opinion and has the most weight. This is the sole value report that is acceptable for estate and gift tax purposes, divorce proceedings, and many other situations where it is anticipated that the appraiser will have to appear in court. A computation of value, a different kind of valuation report, can be used for informal purposes, settlement negotiations, establishing a parameter or benchmark for the value of the firm, as well as the majority of financial planning needs. The Statement on Standards for Valuation Services contains guidelines for conclusion of value and calculation of value that AICPA members must adhere to 1. CPAs who are not AICPA members should specify in their reports the standards they are adhering to and whether they have other credentials. It is challenging for an appraiser to establish credibility in the lack of any credentials, but her history of work in these areas would be considered. Many CPAs undertake “informal” valuations to reduce fees, particularly for financial planning objectives. These typically don’t adhere to any standards, thus they might not include all the steps and methods required to arrive at a reasonable valuation, perhaps leading to a valuation that isn’t in the client’s best interest.
If a financial planner who is a CPA is also certified to undertake valuations, there may be a problem with the valuation’s independence if a formal conclusion of value is required.

Who Are Involved in the Valuation?

Most financial planning is done informally between the individual customer and CPA (and occasionally, family members). However, when there is a specified objective, other parties may be relevant, and distribution to them should be taken into account; for instance, in estate, gift, and succession planning, the IRS may require assessments. Employees and their advisors would be involved in valuations for employee remuneration purposes, whereas the intended or current spouse would be involved in appraisals for prenuptial agreements and divorce settlements. Although there are normally constraints on who can receive a valuation report, these restrictions are frequently ignored by the individual or their advisors, and the reports can end up in the hands of unauthorized individuals. Reports may also become the subject of a court case and be used as evidence there. For their own safety, people should be warned about these possibilities.

The CPA’s Position

CPA financial experts will encounter a conundrum while giving advice to business owners. CPAs should advise such individuals to hire a professionally accredited valuation expert if they need a value. Additionally, CPAs must carefully assess which valuation premise is acceptable and what kind of valuation report is required in the given situation. The advice given above should assist CPA financial planners in comprehending the valuation procedure and figuring out the most effective ways to explain it to clients who are business owners.

Contact Credo’s Valuation Experts Now!

Need help with determining a company’s enterprise value, the value of its outstanding securities, the value of its stock options, and the value of its intangible assets while ensuring that a company’s intangible assets are appropriately recorded on its financial statements? We have a team of financial experts who uphold the strictest industry standards to deliver each of our services. Contact Credo now to have a better understanding of our team’s capability to provide accurate and useful valuation guidance.