How much is your business worth?
There are several ways to estimate the value depending on the type of sale, the motivations of the buyer and seller, and numerous other factors. In this column, we will examine a few different methods of valuing an ongoing business. Before doing so, allow me to share a personal story.
In the corner of my home office, a hand-made walking cane rests rests against the wall. The handle was stressed into shape, not naturally curved. The cane resembles a “J.”
It was made for my grandfather by a neighbor who lived a quarter mile away after my grandfather got on up in age. The neighbor – I’ll call him Ray – made it from a small tree on his property. I’m not really sure whether it’s made of hickory or oak. What I am sure of is that Ray and my grandfather were poor farmers and were best friends.
This walking stick would probably go for $5.00 at a yard sale, maybe $12.00 on E-Bay or Facebook Marketplace. That is, unless the buyer was yours truly and I knew for certain that it was my grandfather’s walking stick. I’d pay several hundred dollars for it. Why? Because it has so much sentimental value to me. You see, my grandfather was my father figure. My biological father left home when I was four yours old, so I never really knew him. I lived with my grandparents until I was in the third grade, and spent many summers in their rural Mississippi home. After my grandmother had to be moved to a nursing home, my grandfather lived alone in the old home place. When I was 14 years old, he suffered a heart attack, but was still able to get around. However, he needed someone to be with him in the event he suffered another setback and could not call someone. I was then chosen to stay with him, and did so for one year. It was a year that I cherish. Even now, I think of him often and gaze at that walking cane. It reminds me of our special relationship.
So what does that story have to do with the value of a business? The answer is that the story illustrates sentimental value, which is usually the highest of all values. Business owners who founded their businesses often have clouded views of the value of their business because of sentimental value. They know what went into it and what a buyer should pay for it. They soon learn that it is the market that is the ultimate determinant of the value of a business, hence the concept of market value.
Market value is defined as “The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus.” This is the value estimated by most real estate appraisals.
However, market value and sentimental value are not the only types of value.
Liquidation value is another common type of value familiar to most people. They see it in yard sales, some thrift stores, and the like. It assumes a severely shortened marketing time, due to the fact that the seller is under extreme pressure to sell very quickly.
Disposition value assumes a shorter than average marketing time, due to the fact that the seller is under pressure to sell relatively quickly. Note that “extremely” and “severely” are the primary influences when comparing to disposition value.
Going Concern Value is the one that is usually applied to the sale of a business. It assumes that the business will continue operating into the future (as opposed to being liquidated for its assets). Within real estate appraisal, Going Concern Value is commonly referred to as the total value of the real estate plus the business operation. And that definition gives a clue as to how the owner can make a reasonable calculation of the value of their business. There are two values that need combining. First if the value based on the income that the business produces. Net operating income, not gross income. The formula is as follows:
Value = net operating income/capitalization rate.
Think of it this way: What would an investor pay for the income that the business produces?
An investor nowadays would be happy with a 2% return on a savings account investment. But an ongoing business is a riskier investment, so the investor would want much more. Let’s say 15%. Let’s also say that the business has a net operating income, i.e. after all expenses have been paid, of $250,000 per year. Thus, the value of the annual income stream would be $1,666,667 ($250,000/.15). Add to that, the value of the real estate, and the total value of the business is estimated.
Warning: This is an oversimplified version of how to calculate the value of an ongoing business. In most business valuations, there will be numerous other factors to consider. For example, the goodwill of the business, the outlook for future sales, opportunity costs, and much more. As Henry Ford said, “A business that makes nothing but money is a poor business. ”
Valuing a business is the first step in selling a business. Therefore, it pays to hire a professional to provide an unbiased, third-party appraisal of the business.
» PHIL HARDWICK is a regular Mississippi Business Journal columnist. His email address is firstname.lastname@example.org.
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