The three ways appraisers determine the value of your business

In good times or bad, understanding the value of your investments is critically important for making informed decisions. In many cases the "value" is determined by communication with your broker, general number and ratio comparisons in the marketplace or through periodic statements sent by an investment company, brokerage firm or bank. To arrive at the current value of these types of investments, simple mathematical computations yield the value as of a specific date: capital invested + return on investment = current value. Applying this simple formula allows an investor to make decisions regarding the future of his or her investments such as when to reallocate funds, stay put or reinvest elsewhere.

Similarly, for every business owner and regardless of economic conditions, it is important to understand the current value of your business. This is vital information for many reasons that include establishing lines of credit, forecasting working capital needs, equity or capital infusions and, establishing long-term strategic forecasts. Compared to typical investments in securities and stock markets where the market ultimately establishes the price, determining the economic value of a business can be a difficult and meticulous task and one often best left to a certified business valuator.

In the United States, the most widely recognized and accepted standard of value related to business valuations is fair market value. Fair market value is defined by the American Society of Appraisers as "the amount at which a property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts." The willing buyer and the willing seller are assumed to be hypothetical persons dealing at arm's length.

Let's take this concept one step further: Each and every business is unique in some way, whether it is the customer base, market share capture, capital structure, the assemblage of current assets or product base. No two companies are identical in every sense of the word. Tangible and intangible assets often exist; volatile economic cycles, consumer spending and the health of the economy play vital roles in determining the overall economic value of a company. A thorough understanding of these influential factors is necessary and imperative in order to work through the valuation process and keeping up with these fluctuating factors is often not something a business owner has the time to do.

A certified business valuator can assist with establishing value by using the three primary approaches to determining value:

The asset-based approach methodology takes an aggregate of all the assets in the business minus the liabilities to arrive at the asset value. Asset based approaches can be done on a going concern basis or on a liquidation basis. A going concern asset-based approach lists the net balance sheet (fair market) value of the assets minus the (fair market) value of its liabilities. A liquidation asset-based approach determines the net cash that would be received if all the assets were sold and the liabilities paid off. Use of the asset approach is commonly used for companies with a large assemblage of assets.

The income-based approach is predicated on the idea that a business's true economic value lies in its ability to produce wealth in the future. Here, the valuator determines the expected benefit stream using support from the company's past earnings and/or management projections for future earnings potential. The earnings are then normalized for unusual revenue or expenses (discretionary income and expenses), and the expected normalized benefit stream is then multiplied by a capitalization rate. The capitalization rate is determined by several factors including but not limited to: rate of return a reasonable investor would expect on the investment, industry risk, overall economic risk, specific company risk, loss of key personnel and management's ability to effectively operate the company as a going concern.

The market-based approach to business valuation attempts to establish the value by comparison to similar type businesses that have recently sold and where the financial information associated with the transaction is disclosed. This is the least commonly used method as sufficient data and comparable information may not be available or applicable to the business of interest.

In other instances the valuator may consider using a hybrid approach which is typically a combination of the asset and income methods. The use of this approach is fairly common in the manufacturing industry where the balance sheet is comprised of large pieces of equipment, inventory and fixtures. Forecasted future income is also vital in determining a current value; therefore a combination of these two approaches can be used.

Additionally, the application of market multipliers may provide a ball-park value. Using this type of approach is only recommended if the business interest is a uniform operation, there are no unique qualities inherent in the business and/or the interested parties are motivated to settle given vague figures.

The three approaches generally applied are essential guidelines for business appraisals and are a fundamental part of the business valuation process. These approaches are also required for consideration by the SSVS (Statement on Standards for Valuation Services) for all certified appraisal professionals.

If you are looking to buy or sell a business or business interest (whole or fractional), are valuing or dissolving a trust or estate, or simply want to know the true economic value of your business, it's important to find the right business appraiser.

A good place to start is to ensure the appraiser is accredited. The National Association of Certified Valuation Analysts provides a Certified Valuation Analyst designation and an Accredited Valuation Analyst designation. (Get details at www.nacva.com.) Another is the Accredited in Business Valuation designation sponsored by the American Institute of Certified Public Accountants (www.fvs.aicpa.org/).

Derek Thomas is a senior business valuation analyst with Hutchinson Business Valuation Inc. in Reno. Contact him at 826-6336 or derek@hutchval.com.