Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment III)

Preface: Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment III)

Credit: Donald J. Sauder, CPA | CVA

What is a Right Rate of Return?

At the heart of all business valuations is a marketplace rate of return on a business “investment”. This is often either a mathematical divisor or a multiplier. If you are investing in a bank certificate of deposit, rates vary from bank to bank. So likewise do dividend rates from business to business, and net earnings also fluctuate. For instance, if you invest in dividend stocks, what is your expected rate of return on the investment? Always, the higher the risk, the higher the rate of investment return on that asset. Managing the entire chess board of investment rates of return, (a.k.a. investment yields) is the Federal Reserve in the United States.

When an assessment of value is generated on a business, immediately generated is a correlating assumption as to how the credit markets will provide liquidity both for investors and consumers in the future. Liquidity and velocity of money are indicators to economic stability.

Correspondingly, in stable economic conditions, business valuations are higher than in recession conditions. This difference includes, among a multitude of factors, the access to credit for buyers, purchasing power of customers, and the effective rate of return on the investment in that higher risk business environment.

Higher investment rates of return result in lower business value, and lower rates of return result in higher business value because of the investment yield on the business assets. Determining the appropriate rate of return on a business is the work of financial market participants. For instance, valuations can sometimes use an addend approach for a capitalization factor, such as a risk-free rate e.g., Treasury bonds, adding on an equity risk premium rate, with a size premium rate addition, and then frost an industry and company risk premium rate for a summed market rate of return on the investment.

Capitalization rates when they are multiples are a certain percentage. For instance, a three-times multiple is essentially a 33% rate or return for the investment, and a four-times multiple is a 25% rate return. The rate is obtained when dividing one with the multiple. So, a 20% capitalization rate is a five-times multiple of cash flows.

Normalized net income, EBITA, or operating cash flows, and tax effective adjustments and extraordinary earnings or expenses are all part of valuation. Yet appropriate capitalization rates on those earnings can lead to many varying opinions among business valuators.

What about Buyer Discounts?

One precisely misunderstood feature of business valuation is necessary and reasonable discounts for lack of marketability and lack of control or minority interests. Simply capitalizing normalized earnings is not the final value of a business. Too often overlooked among entrepreneurs, there are substantial differences between business ownership of a publicly traded business and that of a private enterprise as an investment. Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.

When valuing a business with a potential and ready buyer, it does not change a fair market value of an enterprise. Fair market value is the price at which two bidders would agree to both purchase the business. When you bid on an asset at an auction, the final bid is not fair market value. It is the second to last bid supposedly because you could immediately sell the purchase for that price in the marketplace. Only you bid that final sales price for an auction asset, and therefore, the asset doesn’t hold that value to any other marketplace participants, other than to your final bid. Does the highest bidder always win?

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment II)

Preface: Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Credit: Donald J. Sauder, CPA | CVA

Factor B is the business’s excess earnings that result in premium valuation from a rate of return on investment from the intangible assets cash flows of management decisions, employee activity, patents, processes, etc. Excess earnings are the net revenues above the ceiling of equity market rates of return on the tangible assets. For example, if a business produces substantial earnings above equity risk premium rate of return on tangible assets the business can appraise for a higher value, because it is a profitable investment grade asset. The key term is investment grade asset.

Economic and industry growth are also added to the goodwill equation with Factor C including the organizations ability to attract new customers and create more products, increase top-line sales volume, and strengthen cash flows. Of note is that recurring revenues  have higher goodwill multiples than transactional revenues, i.e. a bicycle shop has a different economic and industry growth characteristic than a farmer’s market stand, or a car wash.  Therefore the goodwill factors are for these reasons traditionally unique from industry to industry with an expert appraisal value.

Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history!

The Type of Goodwill Matters

Let’s look for a moment at the following picture of personal goodwill. Personal goodwill is from relationships developed between customers or suppliers and a business. The value that it adds for appraisal purposes is certainly controversial for many valuation analysts. One such legendary example of personal goodwill valuation is the Martin Ice Cream Co. v. Commissioner.

In Martin Ice Cream Co. v. Commissioner valuation negotiation with the Tax Court, the final ruling was that intangible assets encapsulated in the shareholder’s personal relationships with key suppliers and key customers were not assets of the shareholder’s corporation. Why? Because there was no corresponding employment contract or non-competition agreement between the selling shareholder and the corporate entity.  In this case, the shareholder, Arnold Strassberg, had developed personal relationships with his customers over a duration of approximately twenty plus years.  For the background, in 1974 the founder of Haagen-Dazs asked Mr. Strassberg to assist with his ice cream marketing expertise and relationships with supermarket owners and managers to introduce Haagen-Dazs ice cream products into supermarkets.

The tax court essentially ruled that the goodwill was not a corporate asset because while at the corporation, Mr. Strassberg was instrumental in the design of new ice cream packaging and marketing techniques; there were no legal contracts for his services on behalf of corporate operations.

This tax opinion, can reduce the value of a certain corporate stock appraisal because it is personal goodwill and not corporate goodwill, yet that value is still an asset. This area of tax law is best deferred to experts, because it is a double-edged sword in business appraisals depending on if you’re a buyer or a seller.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Preface: Anyone with a keen interest in history is familiar with the Tulip Mania in Holland. We can learn much from business history looking at enterprises during the Tulip Mania with regards to keeping business valuations in perspective for privately owned businesses today, and further elicit gems for consideration in accurate appraisal values from a proper perspective.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Credit: Donald J. Sauder, CPA | CVA

Introduction

As a process and set of procedures used to estimate the economic value of a (business) owner’s interest in an enterprise, business valuation is both an art and science. It is governed with models for financial market participants to determine the price(s) they are willing to pay or receive as a value to achieve a transaction of an enterprise at a set price. Yes, those financial market participants can be independent certified appraisers; and opinions are entitled to non-accredited business owners too.

Euphoric business valuations like euphoric investments, are as realistically permanent as the Dutch Tulip Mania. During the Dutch Golden Age the people of Netherlands had money up and down the social class. It was the richest country in Europe from the country’s great success in commerce and global trade. The aristocrats figuratively had money burning holes in their pockets, and so did the middle-class merchants, artisans, and tradesmen. With that extra cash, they had richer door man opportunities  to enjoy both leisure and investments.

At that time in the Netherlands, as has been for millennium, neighbors talked to neighbors, shopkeepers with candlestick makers, and dentists with booksellers. Tulip speculation was one such drawing conversation topic. Anyone with a keen interest in history is familiar with the rest of the story of the Tulip Mania in Holland. The point is that we can learn much from business history in Holland during the Tulip Mania with regards to keeping business valuations in perspective for privately owned businesses today, and further elicit gems for consideration in accurate appraisal values.

Few would counter argue this fact– we are in a business Golden Age. Since the long forgotten 2008 economic malaise, many entrepreneurs in management positions have minimal if any experience guiding an organization during monsoon conditions in the economic climate. Yes, it is the “Good old Days”.

Is the Question a matter of Goodwill?

Often, the most controversial feature of business valuation is goodwill. Many business owners have a realistic assessment of what their business assets are worth as tangibles, e.g., the computers, equipment and machinery you can see, but business goodwill is subjective. As the cherry on top of business value, goodwill is always a subjective value given to the intangible assets of a for-profit enterprise. Further, the true value is only verified with an exact balance at sale of a business interest.

Goodwill has multiple factors in a business appraisal. Let’s first look at Factor A: the going concern value of the goodwill. That is, the probability of the business continuing to produce net income effectively following the transferring of ownership in the capital of tangible assets , employees, and management.

This going concern factor assesses the appraisal value with the business continuing as a successful going concern after the transaction. The greater the probability of the going concern success feature in the business from systems , processes, location(s), name recognition, web reviews, customer loyalty, and transition guidance, the higher this component of goodwill.

Unfortunately, too many businesses have not invested in developing standard operating procedures or developing seamless transition plans years in advance to maximize this Factor. Their businesses are managed will less than optimal efficiency and hence resulting in reduced goodwill appraisals. Yet, the enterprises that have invested appropriately, should expect a premium valuation appraisal. An experienced valuator can assess this rather effectively and efficiently  from accurate cash flows, narrative, and analytical procedures.

End of Segment I