The purpose of this article is to introduce the reader to a proven methodology of placing a value on your business. With few exceptions, our business is our most important asset. Most of those who own a successful small business have important reasons for wanting to know how much the business is worth, even if it is not, at present, for sale.

It is wise to start thinking about and planning for succession long before you need to transfer ownership - whether to the next generation, or to another company or owners.

The basis approach of this evaluation method is similar to that used by some professional appraisers of small businesses. It assumes that a business is worth the value of its assets, plus a premium for goodwill when the earnings are sufficiently high.

What is unique about this method, is that it establishes a precise format for the redefinition of earnings as a discipline, through the use of a detailed form, so that the method can be followed by anyone at all familiar with basis business accounting.

THE SEVEN (7) BASIC STEPS IN PREPARING AN ACCURATE BUSINESS VALUATION:
The 7 steps involved are as follows:

1. Prepare a stabilized income account.
2. Determine the value of tangible assets.
3. Determine the "Cost of money" (annual investment cost of tangible assets).
4. Determine "Excess earnings" (Earnings as determined in Step 1, less "Cost of money".
5. Calculate a multiple for excess earnings.
6. Calculate value of excess earnings (excess earnings as Determined in Step 5, times the multiple derived in Step 5)
7. Determine total business value by adding asset value

(Step 3) to value of excess earnings (Step 6).

The calculations of the 7 steps are as follows:

1. Calculate the "real earning power" of the business by preparing a Stabilized Income Account. Real earning power)is defined as what you think earnings will be over a twelve month period beginning on the date of the valuation. Do not simply estimate your entries that may have been distorted by such factors as accounting techniques used, non-recurring circumstances that have affected earnings positively or negatively, and so forth.

This "stabilized" or "adjusted" earning figure cannot be based on wishful thinking or used to disguise basic problems in a business (such as chronically high cost of production or sales due to inefficiencies). This statement of real earning power will be scrutinized carefully in the event of an actual sale or transfer, and is best if all of the assumptions used to adjust income and expense entries are stated in writing in the evaluation.

Chart I, shows a summary of reported earnings for a fictional company alongside the stabilized earnings. At the bottom of the chart are the notes that explain why the adjustments were made (in a careful evaluation, the notes will be much more detailed, and possibly supported by other data, depending on the purpose of the valuation).

Other adjustments include replacing owner's salaries, which fluctuate greatly in real-life circumstances, with an owner's salary based on what is would cost to hire a paid manager. Depreciation expense, an item that is often meaningless in past financial statements, is replaced with an expense called "replacement fund". Think of this as a sinking fund sufficient to build savings to provide for normal replacement as equipment wears out.

Note, that the stabilized earnings do not reflect interest expense, since interest expense can fluctuate according to the structure and the special circumstances of the owner. Instead, at a later stage, the term "cost of money" will be defined and used instead.

2. Calculate the value of all tangible assets. To do this properly, a well-qualified appraiser may be needed. This appraisal will cover the value of land, buildings, inventory, furnishings, and equipment of all types needed to conduct the business.

Chart II summarized the value of tangible assets of the company currently being used as an illustration.

3. Determining the cost of money. The term, cost of money, as used here, is a specialized term defining the annual investment cost of owning the tangible assets of the business (as defined in Step 2 above). It is a substitute for interest expense. The rate used may differ from the current prime rate or the actual interest rate that may have to be paid under any particular set of circumstances.

If one were to base the valuation process on prime rate, it would lead to a situation where business values went up and down as wildly as the prime rate does; and the market just doesn't work this way. Therefore, one settles on a figure that is somewhat more stable.

It is also somewhat lower than the prevailing interest rates when most of the assets involved offer considerable tax shelter, as they do in this example. This may be called "the underlying interest rate". To keep it simple, a rate that is about four points above the inflation rate is generally used in these instances. In this illustration, 12 % is being used.

The "cost of money" figure applies only to the tangible assets of the business, as calculated in Step 2, above.

Chart III shows how this calculation has been made for the example being used.

4. Determine a figure known as excess earnings. This figure represents how much the business can be expected to earn after the cost of money (as defined in Step 3 above) is deducted from stabilized earnings (as defined in Step 1 above). It is a simple calculation, as shown in Chart IV.

5. Determine an excess earnings multiple. This multiple must be approximate for "the business being examined". This multiple will be used in the following step to determine what value to place on the excess earnings as calculated in Step 4, above. This multiple reflects the risk, stability, and other factors inherent in the business under study.

Chart V is the tool that is used to arrive at a correct multiple. It incorporated, in short hand, the basic values that the market places on the quality of earnings of a particular company.

6. Calculate the value of excess earnings. The multiple developed in Step 5 above, will be used with the excess earnings figure as shown in Chart 6.

7. Determine the total business value. Total business value is determined by adding the value of the assets (Chart 2), to the excess earnings (Chart 6). Chart 7 displays these calculations.


CONCLUSION:

The steps above, if followed carefully, offer a common sense approach to determining the value of a business. They suggest (accurately) that a business is worth the market value of the assets that are necessary to conduct the business, plus, where appropriate,a premium if the business is especially profitable.

A closer examination will reveal that the methodology used to determine the premium to be paid for particularly high earnings we quite conservatively calculated. In the example used above, a multiple of 3.9 was calculated. This means, that if the business sold at the same price as the valuation suggests, the purchaser will receive a return on investment of 25.6 % on the portion of the purchase price that is not backed up by tangible assets (payback in 3.9 years equals an annual return on investment of 25.6 %.

It may be seen, that many businesses have no excess earnings. In this case, the business is likely to be worth no more than the value of its tangible assets. A seller cannot expect to charge a premium price (known in accounting terms as "goodwill") if the business cannot generate more than enough funds to pay for the assets.

In fact some valuations may produce negative excess earnings figures. In such a case, the business is not even worth the value of it's assets, and the best course of action may be to liquidate the business.

NOTE: A summary form is included as an ADDENDUM that can be used to follow this methodology to determine the value of a particular business. In all probability, someone following this approach carefully and objectively will arrive at a conclusion of value that is quite close, within 5 % and 10 %, to what the business would sell for, given adequate time and effort to find a qualified arm's length buyer.


CHART 1 SAMPLE COMPANY VALUATION

STABILIZED INCOME ACCOUNT
ACTUAL 199_ % Stabilized 12 months) %

Sales (1) $ 650,000 100.0 $ 700,000 100%
Cost of Sales (2) (197,600) 30.4 (212,800) 30%
Operating Labor (3) (187,000) 28.8 (201,600) 28%
Gross Profit (3) 265,200 40.8 285,600 40%

Sales Expenses * (86,750) 13.3 (92,400) 13%
Administrative Expense * (52,650) 8.1 (42,000) 6%
Executive Salaries (3) (40,000) 6.2 (49,000) 7%
Replacement fund/depreciation. (11,700) 1.8 (21,000) 3%
Maintenance & Repairs (5,200) 0.8 ( 7,000) 1%
Unclassified (5,200) 0.8 (7,000) 1%
Total Overhead Expenses (201,500) 31.0 (218,400) 31%

Indicated Pretax profit $ 63,700 9.6 $ 67,200 9%
=====================================================================
Assumptions:

1. Sales will increase at inflation rate assumed to be 7.7 %.
2. Operating costs will remain at constant percentages.
3. Executive (owner) salary should be increased by $ 9,000 to reflect current salaries offered in comparable companies.
4. Replacement fund of $ 21,000 will be substituted for depreciation expense. This is ample to replace assets as they wear out.
* Minor adjustments were made through a detailed analysis of each Lne item or expense and reflect best estimates.
======================================================================
CHART 2 VALUE OF TANGIBLE ASSETS

Land $ 20,000
Buildings 120,000
Inventory 60,000
Equipment 60,000
Working Capital required 40,000
Total tangible assets $ 300,000
======================================================================

CHART 3 COST OF MONEY

Value of tangible assets
"Underlying" interest rate $ 300,000
"Cost of Money" 12 %
(.12 X $ 300,000) $ 36,000

==============================================================

CHART 4 EXCESS EARNINGS

Stabilized earnings (From Chart 1) $ 67,200
Cost of Money (From Chart 3) (36,000)
Excess earnings $ 31,200
======================================================================
CHART 5 CALCULATING THE MULTIPLE
(Key to Rating Scale)

RISK RATING (From 0 to 6)
0 = Continuity at risk
3 = Steady income likely
6 - Growing income assured

COMPETITIVE RATING (From 0 to 6)
0 = Highly Competitive in unstable market
3 = Normal Competitive conditions
6 = Little competition in market, high cost of entry for new competition

INDUSTRY RATING (From 0 - 6)
0 = Declining Industry
3 = Industry growing somewhat faster than inflation
6 = Dynamic industry, rapid growth likely

COMPANY RATING (From 0 to 6)
0 = Recent start up, not established
3 = Steady growth, slightly faster than inflation rate
6 = Dynamic growth rate

DESIRABILITY RATING (From 0 to 6)
0 = No status, rough or dirty work
3 = Respected business in satisfactory environment
6 = Challenging business in attractive environment

RATING FORMULA (Showing values used for this business example)

Risk 4.0
Competitive situation 3.0
The industry 3.5
The company 5.0
Company growth 4.0
Desirability 4.0
Total 23.5

Excess earnings multiple (total - 6) 3.9
=======================================================================
CHART 6 VALUE EXCESS EARNINGS

Gross Earnings (From Chart 4) $ 31,200
Multiple (From Chart 5) X 3.9
Value of excess earnings $ 121,680

============================================================================
CHART 7 TOTAL BUSINESS VALUE

Value of assets (From Chart 2) $ 260, 000
Value of "excess earnings" (From Chart 6) +121,680
Total Business Value $ 381,680

* NOTE: The $ 40,000 used in Chart 2 for required working capital has not been included here. A new owner will have this amount available in addition to the purchase price.

SHORT FORM FOR VALUATION

1. Sales, estimated for 12-month further period. __________________

2. Operating expense, stabilized as outlined in article to eliminate all anomalies.
Include cost of goods and operating labor. ______

3. Administration expenses to be prepared after close examination of normal expenses requiredthat are not included in Line 2. Do not include owner's salary, depreciation or interest expenses. _______

4. Owner's salary. Should be what would be paid for competent hired manager. __________________

5. Replacement fund. This is a "sinking fund" that replaces the book depreciation expenses. It is "charged" to earnings so that funds wil be available to replace assets as they wear out.

6. "Stabilized' EARNINGS (Line 1 less Lines 2-5) ___________________

7. Value of assets plus necessary working capital.
A. Land ___________________
B. Buildings ___________________
C. Inventory: Raw ___________________
Work in Process ___________________
Finished ___________________
Resale Inventory ___________________
Total Inventory ___________________
D. Equipment ___________________
E. Furnishings ___________________
F. Other tangible asset value ___________________
G. Total tangible asset value (A - F) ___________________
H. Working capital needed ___________________
I. Tangible assets & working capital (G & H) ___________________

8. "Underlying" interest rate (use current inflation rate) ___________________

9. "Cost of Money"
A. Reenter tangible asset value + working capital from Line 7-I ___________________
B. Reenter underlying interest rate from Line 8 (Use Decimal) ___________________
C. Multiply 9-A by 9-B ___________________

10. "Excess earnings"
A. Reenter stabilized earnings (Line 6) ___________________
B. Reenter "Cost of Money" (Line 9-C) ___________________
C. Excess earnings (Line 10-A less 10-B ___________________

11. Calculate multiple (Refer to Chart 5 in text, (Ratings are 0 - 6)
A. Risk ___________________
B. Competitive ___________________
C. Industry ___________________
D. Company ___________________
E. Growth ___________________
F. Desirability ___________________
G. Total ___________________
H. Total - 6 ___________________

12. Value of excess earnings
A. Reenter excess earnings (Line 10 - C) ___________________
B. Reenter multiple (Line 11 - H) ___________________
C. Value of "Excess earnings" (12 - A & 12 - B) ___________________

13. Total business value
A. Reenter asset value (Line 7 - G) ___________________
B. Reenter value of "excess earnings (Line 12-C) ___________________
C. Total business value (13 -A & 13 - B) ___________________

CHART 1 CALCULATION FORMS

STABILIZED INCOME ACCOUNT
ACTUAL 199 % Stabilized 12 months) %

Sales (1) $ _________ 100.0 $___________ 100%
Cost of Sales (2) _________ _____ ___________ ____%
Operating Labor (2) _________ _____ ___________ ____%
Gross Profit (2) _________ _____ ___________ ____%

Sales Expenses * _________ _____ ___________ ____%
Administrative Expense * _________ _____ ___________ ____%
Executive Salaries (3) _________ _____ ___________ ____%
Replacement fund/depreciation _________ _____ ___________ ____%
Maintenance & Repairs _________ _____ ___________ ____%
Unclassified _________ _____ ___________ ____%
Total Overhead Expenses _________ _____ ___________ ____%

Indicated Pretax profit $ $ %
=======================================================================
Assumptions:

1. Sales will increase at inflation rate assumed to be ______%.
2. Operating costs will remain at constant percentages.
3. Executive (owner) salary should be increased by $ _______ to reflect current salaries offered in comparable companies.
4. Replacement fund of $_______ will be substituted for depreciation expense. This is ample to replace assets as they wear out.
* Minor adjustments were made through a detailed analysis of each line item or expense and reflect best estimates.
=======================================================================

CHART 2 VALUE OF TANGIBLE ASSETS

Land $_________
Buildings __________
Inventory __________
Equipment __________
Working Capital required __________
Total tangible assets $ ________

===================================================
CHART 3 COST OF MONEY

Value of tangible assets
"Underlying" interest rate $ ________
"Cost of Money" _______%
$ ________
=======================================================================

CHART 4 EXCESS EARNINGS

Stabilized earnings (From Chart 1) $ _______
Cost of Money (From Chart 3) _______
Excess earnings $ _______
======================================================================

CHART 5 CALCULATING THE MULTIPLE
(Key to Rating Scale)

RISK RATING (From 0 to 6)
0 = Continuity at risk
3 = Steady income likely
6 - Growing income assured

COMPETITIVE RATING (From 0 to 6)
0 = Highly Competitive in unstable market
3 = Normal Competitive conditions
6 = Little competition in market, high cost of entry for new competition

INDUSTRY RATING (From 0 - 6)
0 = Declining Industry
3 = Industry growing somewhat faster than inflation
6 = Dynamic industry, rapid growth likely

COMPANY RATING (From 0 to 6)
0 = Recent start up, not established
3 = Steady growth, slightly faster than inflation rate
6 = Dynamic growth rate

DESIRABILITY RATING (From 0 to 6)
0 = No status, rough or dirty work
3 = Respected business in satisfactory environment
6 = Challenging business in attractive environment

RATING FORMULA (Showing values used for this business example)
Risk _____
Competitive situation _____
The industry _____
The company _____
Company growth _____
Desirability _____
Total _____
Excess earnings multiple (total - 6) _____

=====================================================
CHART 6 VALUE EXCESS EARNINGS

Gross Earnings (From Chart 4) $ ______
Multiple (From Chart 5) X ______
Value of excess earnings $ ______
====================================================================

CHART 7 TOTAL BUSINESS VALUE

Value of assets (From Chart 2) $ _______
Value of "excess earnings" (From Chart 6) +_______
Total Business Value $ _______

* NOTE: The amount used in Chart 2 for required working capital has not been included here. A new owner will have this amount available in addition to the purchase price.