Understanding Business Valuation: A Practical Guide to Valuing Small to Medium Sized Businesses, Fourth Edition
Written by Gary Trugman, Understanding Business Valuation: A Practical Guide to Valuing Small-to Medium-Sized Businesses, simplifies a technical and complex area of practice with real-world experience and examples. Trugman's informal, easy-to-read style covers all the bases in the various valuation approaches, methods, and techniques. Readers at all experience levels will find valuable information that will improve and fine-tune their everyday activities.
Topics include valuation standards, theory, approaches, methods, discount and capitalization rates, S corporation issues, and much more. Author’s Note boxes throughout the publication draw on the author’s veteran, practical experience to identify critical points in the content. This edition has been greatly expanded to include new topics as well as enhanced discussions of existing topics.
New and expanded in this edition:
- New content on statistics for business valuation and economic damage analyses.
- Forecasting techniques for business valuation and economic damages.
- Pass through entities including a discussion of the leading models used to estimate taxes.
- An accompanying CD-ROM that includes new sample reports and one of the most comprehensive bibliographies in the business.
- The discounts and premiums section has been greatly expanded to included discussion of additional types of discounts as well as quantification techniques used to calculate marketability discounts. This includes a discussion on how to use the Black-Scholes Option Pricing Model.
About the Author:
Gary R. Trugman is a Certified Public Accountant licensed in the states of New Jersey, New York (inactive), and Florida. He is Accredited in Business Valuation (ABV®) by the AICPA and is a Master Certified Business Appraiser (MCBA) as designated by the Institute of Business Appraisers Inc. He is also an Accredited Senior Appraiser (ASA) in business valuation by the American Society of Appraisers. Gary is regularly court appointed and has served as an expert witness in federal court and state courts in several jurisdictions, testifying on business valuation, business and economic damages, and other types of litigation matters. Gary is currently the chairperson for business valuation education for the American Society of Appraisers and serves on its ethics committee. He was presented with the Volunteer of the Year Award by the AICPA in 2011 for outstanding service in furthering the goals of the business valuation profession. Gary has previously served on the AICPA’s ABV Examination Committee, the AICPA’s subcommittee working with the judiciary, the ABV credentials committee, the executive committee of the management consulting services division, and the business valuation and appraisal subcommittee. He is the past chair of the Florida Institute of CPAs’ litigation and business valuation committee and was formerly on the New Jersey Society of Certified Public Accountants’ litigation services committee, business valuation subcommittee (past chairman), and matrimonial committee.
INTRODUCTIONThe asset-based approach is also commonly known as the cost approach or the replacement cost approach. Sometimes you may even see this approach called the asset accumulation approach. In this approach, each component of the business is valued separately. This also includes liabilities. The asset values are totaled, and the total of the liabilities is subtracted to derive the value of the enterprise.
The valuation analyst estimates value by adjusting the asset values of the individual assets and liabilities of the business to fair market value. Some valuation analysts will use this approach for the tangible assets only and consider it to be complete. In fact, I used to do this. However, as we get older, we get wiser. This approach, like the market and income approaches, is intended to value the entire company. This means that the tangible assets, as well as the intangible assets, should be valued and the liabilities subtracted. You may have to use other approaches to value the intangible assets, but I will discuss that later. If you only use this approach to value a company, you could overstate the value of the business as a going concern because if there are insufficient earnings to support the asset base, you will end up with a higher value under this approach than the other approaches.
I used to think that valuing the tangible assets and liabilities would result in a “floor” value for an enterprise being valued as a going concern. I hate to admit it, but I was wrong. The purpose and function of the assignment (remember that from the beginning of this book?) has a lot to do with whether it can truly be a floor value. I will address this in greater detail later in this chapter.
COMMON APPLICATIONS OF THE ASSET-BASED APPROACH
The asset-based approach is most commonly applied to the following types of business valuations:
In all of these instances, the valuation subject will have most, if not all, of its value in its tangible assets or identifiable intangible assets, such as copyrights, patents, or trademarks. Intangible assets, such as goodwill, will not play an important role in the value of this type of enterprise. If goodwill or another type of intangible value exists, it will be added to the value.
This approach is generally not used for the following types of business valuation assignments:
Service businesses and asset light businesses generally get the bulk of their value from intangible assets. Therefore, it seems logical that the asset-based approach would not be an effective means of valuing these types of entities. Operating companies are generally valued based on the ability of the company to generate earnings and cash flow and, therefore, rely on a market or income approach for the determination of their value. If you recall, Revenue Ruling 59-60 indicates the following in Section 5:
Weight to Be Accorded Various Factors. The valuation of closely held corporate stock entails the consideration of all relevant factors as stated in section 4. Depending upon the circumstances in each case, certain factors may carry more weight than others because of the nature of the company’s business. To illustrate:
(a) Earnings may be the most important criterion of value in some cases whereas asset value will receive primary consideration in others. In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies that sell products or services to the public; conversely, in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued.
(b) The value of the stock of a closely held investment or real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type, the appraiser should determine the fair market values of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit consideration when appraising the relative values of the stock and the underlying assets. The market values of the underlying assets give due weight to potential earnings and dividends of the particular items of property underlying the stock, capitalized at rates deemed proper by the investing public at the date of appraisal. A current appraisal by the investing public should be superior to the retrospective opinion of an individual. For these reasons, adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned, than any of the other customary yardsticks of appraisal, such as earnings and dividend paying capacity.
Minority interests will usually not be valued using an asset-based approach, because the minority shareholder does not have the ability to liquidate the assets. However, do not take this as a hard and fast rule. In chapter 21, I discuss valuing limited partnership interests in family limited partnerships, which is similar in many respects to valuing minority interests. All of this stuff will be explained further in my discussion about adjusting the balance sheet later in this chapter. Meanwhile, as a general rule, if the shareholder cannot get to the cash flow that will be generated by selling off the assets, this approach will not get to the value of the cash flow to the minority shareholder. After all, value is based on the future benefits stream that will flow to the investor.
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