Calculation of value is the process of determining business value, ownership interest, or value of intangibles whereas an appraisal is the process of developing an opinion of value.
Appraisals are prepared by certified appraisers and are accepted by courts, Internal Revenue Service, and banks; calculation of value is not.
The value or worth of a business is measured in terms of its assets and goodwill. Assets are an aggregation of tangible things like cash, furniture, fixtures and equipment, real estate, building, and inventory. Goodwill is a composition of things that make a business effective like practice, reputation, location, track record, and standard procedures that lead to superior income. Thus, goodwill can be calculated as total value minus fair market value of the tangible assets.
Total value is the price at which a business changes hands. The likelihood of an exchange is a function of the knowledge and will of the parties involved. The issue is parties are usually willing but not all are knowledgeable. So, in reality, there are people who expect too much, offer too little, or pay too much for a business. Consequently, the goal of a calculation of value would be to determine a price that results in a change of ownership.
To illustrate, let’s examine the calculation of business-only value. Business-only refers to buying the “cash business” and leasing property. Here, the buyer is purchasing the available cash flows of a business throughout the term of a lease. So, it is cash flow that allows a potential buyer to determine the true investment value in the business.
Figure 1 (Top) – Higher rates of return Figure 2 (Bottom) – Risk reward ratio
The equation to test business-only or preliminary value is two to four times available cash flow. However, since cash flow is a reward, its value needs to reflect the risk associated with obtaining it. For example, the greater the risk, the lower the earnings multiple (or the higher the cap rate) whereas the lower the risk, the higher the multiple (or the lower the cap rate).
The cap or capitalization rate is net operating income (EBITDA) divided by the value or selling price.
Factors used in the multiplier calculation are earnings risk, barriers to entry, dependency on management, market position, social desirability, alternative investments, and others.
To illustrate, our example wash is beginning its fourth year of operation. Net operating income is $318,750. Earnings before taxes and depreciation are $146,814. Start-up expenses were $2.5 million. Capital investment was $500,000.
This is an established business with a good market position, some competitive pressure, and requires continual management attention. The multiplier has been calculated to be 3.5 for this company. Applying the valuation formula results in a preliminary or business-only value of $1,115,625 ($318,750 X 3.5).
At the end of year three, the company has assets of $1,080,220 (depreciated F/F/E) and $800,000 in real estate (fair market value). So, value for 100 percent of the company would be the sum of the preliminary value and assets or roughly $3.0 million. This would be a cash-on-cash return of 29.4 percent (EBTD/investment) and a payback period of 3.41 years.
If the business sold for $3.0 million, the three-year average return on investment would be 35.5 percent. Risk reward ratio is 2.1. Arguably, this could be considered a moderate rate of return on a typically safe investment.
Shown in Figure 1 are higher rates of returns based on our model.
In the final analysis, buyers and sellers must decide what the business is worth. For example, someone who spent considerable time and energy to build a reputation and superior earnings is going to want a premium for the sweat equity expended, whereas a person new-to-the-industry would seek a lower price to offset their lack of experience and skill (greater risk).
Bob Roman is president of RJR Enterprises – Consulting Services (www.carwashplan.com). You can reach Bob via e-mail at firstname.lastname@example.org.