Valuing A Business
Besides tax questions, the most common inquiries I receive have to do with how to appraise the value of a small business, either for possible purchase or sale. The actual details of how to do this are too much to include here. However, this is how I answered a client's recent question about possibly buying an existing business.

Business valuations are very tricky because the values can have a wide range. Basically, the low end is the distress sale value; what you could get if you held an auction for the hard assets with very short notice.

The high side of a business valuation is capitalized earnings. You look at the expected net profit without deducting anything for interest, depreciation, income tax, or owner compensation. You then divide the annual expected net income by the rate of return you want to earn. For example, if you want to earn 20%, you would divide the net of (using your figure) $150,000 by 0.20. This gives a value of $750,000. The higher the capitalization rate you use, the lower the valuation and vice versa (lower rate = higher valuation).

So, we end up with a very wide range of acceptable values for the business. Your goal, as well as the seller's, is to come to an agreement somewhere in between.

I'm sorry I can't be more definitive; but that just isn't possible with a business purchase.

I'd be glad to discuss the various options in more detail if you want.

This reminds me of the controversies around business values during the dot-com stock bubble of the 1990s. I wrote several articles decrying how insane and unjustifiable the prices were, and I was severely criticized by some financial pros who claimed that old valuation methods were obsolete for the new modern era. I stuck to my guns and was obviously proven right.

If a company has no hard assets or profits, the only reason to pay anything for its stock is based on pure speculation, or what is often called the "greater fool theory." The only way you can ever expect to recoup your investment is if someone more ignorant than you are can be found to buy the stock from you. The entire run-up in the dot-com stocks was based on that premise and as was inevitable, the supply of fools eventually ran out.

Unfortunately, we are destined to see this exact behavior again, as the collective memory of the public is so short and the ability to learn from past mistakes is very limited.

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 9/04/2004 01:53:00 PM Send this post: