Business Valuations (28 QUESTIONS) Flashcards
(135 cards)
1
Q
What are standards v the approaches and methods?
A
The approaches and methods are used to establish [fair market value], and the term [FMV] is a standard under which various approaches and methods are employed.
2
Q
What are the 4 standards of value?
A
- FMV
- Fair Value
- Investment Value
- Intrinsic Value
3
Q
What is the Fair Market Value standard?
A
FMV is the price, expressed in terms of cash equivalence, at which property exchanges hands between a hypothetical willing and able buyer and seller, acting in an arm’s length in an open and unrestricted market where neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts
4
Q
What is the fair value standard of value?
A
Fair Value is often used in dissenting minority interest shareholder suits, which has been either statutorily or judicially defined.
5
Q
What is the difference between Fair Value and FMV
A
The difference between Fair Value and FMV is you ignore discounts. The discounts only apply to FMV really.
6
Q
What is the Investment Value of standard value?
A
Typically this is the value to a specific buyer requiring consideration of buyer specific attributes of the buyer. The value to a specific buyer is opposite to that of the hypothetical buyer assumed in the FMV standard. For example, this may be from an investment point of view and return point of view, the buyer want “X.”
GOOGLE:
The valuation assumes that the business will be sold to a SPECIFIC BUYER who has unique synergies with the business.
7
Q
What is the intrinsic value
A
Value in the hands of the present owner without the sale. This is referred to as “holder value” or as investment value to the business owner. This typically recognizes the business owner will not be selling the business and there is no hypothetical transaction (as there is in the FMV appraisal), and the owner will continue to receive the value of the business into the future
8
Q
What is value in the hands of the present owner without the sale also known as?
A
Holder value AKA INTRINSIC VALUE
9
Q
Which standard value is the most wildly used method
A
FMV
10
Q
What does FMV assume?
A
A hypothetical sale
11
Q
What is not included FMV analysis?
A
It means that any broker’s fees or other sales commissions that would be required to sell the asset is therefore hypothetical and speculative, and should NOT be subtracted from the value. For the same reason, capital gains taxes which would be due from a hypothetical sale should not be subtracted from the value.
12
Q
Should capital gains taxes be included under the FMV standard?
A
NO - because it is a hypothetical sale and therefore speculative
13
Q
What are different types of discounts in business valuations?
A
- Discount of Lack of Marketability (DLOM)
- Discount for Lack of Control (DLOC)–
- Key Person Discount
14
Q
What are Discounts of Lack of Marketability (DLOM)?
A
Some close corporations are difficult to sell on the open market.
This discount reflects the disadvantages of interests that are difficult to market other than minority status.
You should not apply a marketability discount if the comparables selected are of businesses that are likewise difficult to market.
Most of the reported discounts are in the 20%-30% range. A lack of marketability discount cannot reduce the value of a business to less than the total net value of its tangible assets
15
Q
When should you apply marketability discounts?
A
When there are other similarly situated businesses you can use as a comparable
16
Q
When should you NOT apply a marketability discount
A
If the comparables selected are of businesses that are likewise difficult to market.
17
Q
What is the typical range of most discounts for lack of marketability
A
Most of the reported discounts are in the 20%-30% range.
18
Q
Can a lack of marketability discount reduce the value of a business to less than the total net value of its tangible assets?
A
No - a lack of marketability discount cannot reduce the value of a business to less than the total net value of its tangible assets
19
Q
What is a Discount for Lack of Control (DLOC)?
A
the lack of control in the company.
20
Q
What would be an example of when to use a discount for lack of control
A
If you are purchasing 50% of the ownership or less, there may be a discount for lack of control because you don’t have control
21
Q
What is the position on minority control discounts in states that apply a FMV standard
A
A minority discount is generally permitted but it is never automatic
22
Q
When would you NOT apply a minority discount?
A
(a) if you are looking at comparable sales of other minority interests;
(b) where spouses together own a majority, no discount should be applied even where one spouse owns minority because the court is valuing the marital estate’s interest in the business;
(c) the minority owner had effective de facto control of the company. This is usually in the range of 25%-35%.
23
Q
What can a minority control discount not do?
A
A minority discount cannot reduce the value of a business to less than the total net value of its tangible assets
24
Q
What is the key person discount?
A
There is authority for discounting the business that is unduly dependent upon the services of one particular person if that person is not contractually obligated to remain with a company for a substantial period of time.
25
What happens if an expert considers the presence of a key person in setting a capitalization rate under the capitalization of earnings or excess earnings method?
It's a double dip to include this discount
26
Who is subject to paying a premium?
A buyer in a purchase and sale is going to pay more. For example, you could pay a premium if you have majority ownership
27
What is a buy sell agreement?
This is the contract between the owners that provide for the sale of an owner’s interest in the business to their owners.
28
What is a common triggering event that prompts a buy sell agreement?
Common triggering events include death, disability, retirement and divorce.
29
What is the sale price based on in a buy sell agreement
The sales price is determined by a valuation method specified in the agreement.
30
What are common valuation approaches for buy sell agreements?
Common valuation methods included a fixed price, and independent appraisal or a formula approach
31
What is personal good will?
Personal goodwill is the goodwill that adheres to an individual.
It consists of personal attributes to an individual including personal relationships, skill, personal reputation, and various other factors
32
How do states who recognize value to the holder address personal goodwill?
Personal good will is usually not transferable and so states with the “value to the holder” (intrinsic value which is value to the present owner without sale bc it recognizes that the owner will not be selling the business and there is no hypothetical transaction) premise usually do not require it to be distinguished from enterprise goodwill
33
What are factors that indicate personal goodwill?
1. Age and Health of the professional;
2. Professional’s Demonstrated Earning Power;
3. Professional’s Reputation in the community for Judgment, Skill and Knowledge
4. Professional’s Comparative Professional Success; and
5. The nature and duration of the professional practice, whether as a sole practitioner or contributing member of a partnership or corporation.
34
What is enterprise goodwill?
Enterprise goodwill is favorable consideration shown by the purchasing public to the goods or services known to emanate from a particular source.
Customers return to an enterprise based upon its location, staff, telephone number, facilities and the reputation of the overall entity.
It is the goodwill adhering to an entity regardless of the input of any specific individual
35
Is enterprise goodwill transferable?
Upon selling the business, one has the ability to transfer enterprise goodwill to the buyer.
36
What are factors to identify enterprise goodwill?
a) appropriate compensation package for the replacement of the spouse;
(b) which customers would follow spouse if departed;
(c) look at competitors and would pricing strategy need to change upon departure of spouse;
(d) who would spouse leaving effect the operating efficiency;
(e) qualifications of remaining personnel;
(f) tangible evidence of entity goodwill (i.e. databases, intellectual property, trade secrets);
(h) would departure of spouse change the operating risk of the business; and
(i) any employment contracts between the professional spouse and business that would spouse from competing
37
What is the assumption for sale when there is enterprise goodwill?
That upon selling the business, one has the ability to transfer the enterprise goodwill to the buyer..
38
Is going concern value the same as goodwill?
No -- going concern value is not the same as goodwill.
39
What is going concern value?
Going concern value is the intangible value attached to the assemblage of assets of the business, including the business’s fixtures, equipment and its assembled workforce.
GOOGLE:
It is value that assumes the company will remain in business indefinitely and continue to be profitable
40
What is business goodwill not concerned with?
Business goodwill is not concerned with physical assets; instead, it can be viewed as the excess earnings a business produces due to its reputation and skill, among other things.
41
What is personal goodwill concerned with?
Personal goodwill concerns the excess earnings reliant on the practitioner’s personal attributes.
42
What is fair value?
Fair value can entail an exchange, but not necessarily from a willing seller. Fair value may also assert that a lack of intention to sell the business prevents its valuation as a value in exchange.
43
In general, when do we consider a valuation to be fair value?
Generally, if a valuation takes a pro rata portion of the enterprise value without shareholder-level discounts, we considered it to be fair value
44
What may courts do to compensate the non-title spouse
The courts may look to compensate the non-titled spouse for the value generated during the marriage but realized after the divorce.
45
How do SOME courts view discounts ?
A court evaluating discounts may see the application of discounts as an unfair advantage to the party that will continue to enjoy the benefits of the asset.
46
Why are there no discounts applied in Fair Value jurisdictions?
If you think of a shareholder entering into a partnership, the shareholder has the expectation of the sharing in the benefits of the business over the course of his or her life or the life of the contract. Should those expectations be breached, the court looks to fairly compensate the individual. Marriage is viewed as an economic partnership where each party has an expectation of sharing the economic benefits generated during the marriage. Therefore, the court may view discounts as unfairly benefiting the owner spouse at the expense of the non-owner spouse.
47
What happened in Bobrow v. Bobrow?
The husband had a partnership interest in Earnst & Young and his partnership agreement limited the owner’s interest to the value of the capital account, thereby excluding goodwill. The agreement applied only to a transaction of his partnership interest such as resignation, retirement or death. The court recognized that the assets of E&Y belonged to the institution of which each partner had a share. These institutional assets included intangible assets such as E&Y’s trade name, reputation, etc. All of these assets were transferable to an outside purchaser. The court included the value of the enterprise goodwill in valuing E&Y and awarded the wife the share of the value of the husband’s partnership interest in E&Y based on his pro rata share of the enterprise. Because of its conclusion of value as the prorate share of the enterprise value, this case may be construed as a fair value case under value in exchange premise. While the husband had a buy-sell agreement that limited the value to the capital account, the court valued the husband’s ownership interest similar to the way it would be treated under a fair value standard in a dissenting or oppressed shareholder’s case.
GOOGLE:
Fair value is defined as the pro rata business enterprise value - a total equity value that is not discounted for lack of marketability or lack of control. The fair value is equivalent to the corporations por rata value immediately prior to the corporate action to which shareholders are dissenting
48
What happened in Howell v. Howell?
The husband had a partnership interest in a law firm. Virginia case law provides that while enterprise goodwill that is transferable is marital, personal reputation and future earning capacity are not. The husband’s contract with the law firm provided that when a partner withdraws from the firm, he may receive the balance of his capital account with his share of the firm’s net income through the date of withdrawal. The court looked at whether any goodwill should be included in distributable assets and if so, how to calculate it. The court held that while the restrictive agreement exists, it should not control the value. The court found the DLOC was not an issue worth discounting because no one partner had a controlling interest in the firm. The court similarly found DLOM was inappropriate, as the highest and best use for the husband’s share was to remain with the corporation. Accordingly, the court used the concept that the highest and best use, reasoning the highest value that would be realized was that which would be achieved through the owner’s continued presence, not upon sale, and therefore discounts shouldn’t be applied. This case appears to have elements of FMV (distinguishing between enterprise and personal goodwill, implying a titled spouse’s departure) and investment value (the court considered the highest and best use was the title holder’s continued presence). Thus, the article categorizes it as fair value because it calculates the value as a prorate share of the enterprise value.
49
What is investment value?
Assumes the business will not be sold and the owner will continue to receive benefits from the business or business interest (unless a sale really is occurring).
50
What standard does the investment value fall under?
This standard falls under the Value of the Holder premise.
51
What does the investment value contemplate?
This standard contemplates value not to a hypothetical buyer but to a “particular buyer” which in the context of a divorce, is the current owner (hence, value to the holder). It will apply a going concern value to the current owner.
52
What is often not at issue in an investment value?
The transferability (and therefore, marketability) of personal goodwill is often not at issue because there is likely no intention to sell.
53
What does the use of the investment value standard suggest?
The use of the investment value standard suggests the court is attempting to compensate the nontitled spouse for the economic benefits the titled spouse will receive in the future, regardless of whether that spouse can sell those benefits.
54
What is the intrinsic value
Valuation standard applied to assets that cannot be sold. It is normally determined by measuring the future benefits of ownership and reducing those benefits to present value. Intrinsic value can also properly based upon the present income capacity, as opposed to the actual future earnings of a business.
55
How is value viewed in the premise of exchange?
It is viewed in the context of a sale.
Value in exchange presumes some sort of hypothetical transaction where the business or business interest is exchanged for cash or cash equivalent. The portion of the value that is dependent upon the continued efforts of one party is excluded and viewed as separate property
56
Where does fair market fall in this premise?
Fair Market Value falls under this premise of value in exchange
57
How are owner profits in excess valued?
If there are excess profits generated by some unique inchoate attribute of the owner, the profits in excess of the reasonable compensation are considered personal goodwill and not includable as a marital asset.
58
How are discounts viewed in a value exchange?
A value in exchange premise typically requires consideration of lack of control and lack of marketability discounts to value the owner’s shares in recognition of what a willing buyer would pay for the owner’s shares upon a hypothetical sale.
59
Does a standard of value falling under a value to the holder premise require explicit consideration of discounts?
A standard of value falling under a value to the holder premise does not require explicit consideration of these discounts, as they would be applicable only upon sale, and a sale is not contemplated under this standard.
60
What is the reasoning for the trend to eliminate shareholder discounts ?
The reasoning for the trend to eliminate shareholder discounts in dissenting and oppressed shareholder cases is since neither the buyer nor seller are willing participants, the moving party should be compensated for what was taken -- either the pro rata share of a going concern or what the owner would have reasonably expected to receive from continuing involvement with the enterprise.
61
What insight to treatment of shareholder level discounts provide?
Treatment of shareholder level discounts provide insight into separating state into value in exchange, value to the holder or hybrid states
62
What do value exchange states use?
The FMV standard and require consideration of shareholder discounts, whereas value to the holder states use some version of investment value and do not consider discounts
63
What do hybrid states use?
Hybrid state use a combination of standards and may also use fair value as a standard
64
What does value to the holder consider?
Value to the holder considers the value of a business or business interest in the hands of its owner, regardless if he intends to sell the business.
65
What is the presumption?
The presumption is that no sale will ever take place and therefore, the effect of the owner leaving is not relevant
66
What do value to the holder states generally look to do?
Value to the holder states generally look to identify and value the assets created during the marriage as the result of the joint efforts of both spouses regardless of whether a marketable asset was created or not
67
Which valuation method falls under this premise?
Investment value
68
What do these states consider?
These states consider cash flows received by the title-holding spouse regardless of the assets transferability
69
Is owner compensation considered in valuation?
Typically, the individual attributes are not explicitly excluded but are considered in the selection of reasonable compensation and in the capitalization rates used in the valuation methodology
70
How is personal goodwill viewed in a value to the holder premise?
Personal Goodwill is includable as a marital asset under the value to the holder premise, even though it cannot be sold.
Goodwill in a manner that largely represents an investment value includes personal attributes in the value.
The economic benefits that a going concern may enjoy from (1) established relations with all the markets; established relations with government departments and other noncommercial bodies; (3) personal relationships.
71
Why is using an income or excess earnings method to value a company considered a double dip?
The officer’s compensation in excess of reasonable compensation is added back to the income stream of the company and capitalized. The valuation takes a portion of the owner’s compensation and capitalizes it to value the business, while at the same time, considering it all available for alimony and thereby using it twice - hence the double dip
72
Do shareholder level discounts apply to the value holder premises?
No - Shareholder level lack of control and lack of marketability discounts associated with the value in exchange premise typically do not apply in value to holder premise
73
What does court consider with a shareholder agreement?
The actual use of a shareholder agreement may determine whether it is relied upon by the family court.
For example, the court rejected the value from a partnership agreement in CO case that included a formula based upon the value of receivables plus a portion of the firm’s capital, because the husband was remaining with the law firm.
On the other hand, where the agreement was updated quarterly, it established an intangible value to the business above the value of the partner’s capital account, the court in a NJ case decided the value should not be disturbed.
74
Approaches to Determining Value fall into what two groups
A) the value the business is the total of the value of the individual assets (i.e. the value of the business is the sum of the value of the business’s individual assets minus the total value of the liabilities); and
(B) the business should be valued as a complete entity.
75
Where can the common ground shared by different valuation methods be found / summarized?
It is summarized in Revenue Ruling 59-60, 1959-1 C.B. 237, which states the IRS guidelines for valuing close corporations.
76
Does the IRS state a particular valuation method?
No - the IRS does not state a single valuation method, and instead, provides a list of factors
77
What factors are listed by the IRS for valuation methods?
1. The nature of the business and history of the enterprise from its inception
2. The economic outlook in general and the condition and outlook of the specific industry in particular
3. The book value of the stock and the financial condition of the business
4. The earning capacity of the company
5. The dividend-paying capacity
6. Whether or not the enterprise has goodwill or other intangible value
7. Sales of the stock and the size of the block to be valued
8. The market price of stocks of corporations engaged in the same or similar line of business having their stock traded in a free and open market.
78
What are the different methods and approaches to valuing a business?
(1) Total Value Approach
(2) Going Concern Approach (Valued as a Complete Entity)
79
What is the total value approach
Value is the sum of business’s individual assets
80
What are tangible assets and liabilities
* Accounts Receivable
* Liabilities
* Book Value
81
What is the most common method for valuing goodwill?
Capitalization of Excess Earnings Method
82
How does the capitalization of excess earnings method value work?
Under this method, the court first computes the difference between the actual earnings of the business and the earnings of the “average” or “reasonable” business. This difference is then “capitalized” or multiplied by some number between 1 and 5 (or divided by an equivalent percentage; one court said that a factor of 3 or a percentage of 33% should be used in the absence of evidence another factor would be more accurate). The average earnings should be those of a similar business in the same locality or region. If the court determines the business’s actual earnings are equal to or less than the average earnings, the excess earnings method shows the business has no goodwill.
83
What is the Comparable Sales Method?
While this is the most common method used to value the entire business, some variates can be used to value goodwill alone. If the state only allows marketable goodwill, then actual comparable sales is the best way to provide marketability.
84
What is the Subjective Estimation Method ?
Courts valuing goodwill have also relied upon the subjective estimation made by an expert witness without using any particular rigid mathematical method. This method is not particularly persuasive as an independent valuation method
85
What are the consideration is a Going Concern Approach (Valued as a Complete Entity)
1. Past Valuations
2. Comparable Sales Method Past Valuations
3. Buy-Sell Agreements
4.Capitalization of Total Earnings
86
Are past valuations controlling under the Going Concern Approach ?
This is one factor and while highly persuasive, it is not always controlling
87
What are the considerations under the Comparable Sales Method
Evaluator examines sale of similar business in the same area on or near the date of valuation.
88
What considerations under Buy-Sell Agreements
It is a contract between owners that limits the conditions under which the business can be sold. The agreement will be controlling on the facts only where it was
(a) signed in good faith as a neutral estimate of all elements of value
(b) where it has been followed in the actual practice;
(c) where its value is not greatly dissimilar from the value reached under other valuation methods.
89
What does the evaluator consider with respect to Capitalization of Total Earnings
The evaluator beings with the annual net earnings of the business and the computes value by “capitalizing” the earnings multiplying them by some number determined by the expert.
90
What is the Capitalization of Total Earnings method most similar to?
This method is similar to the capitalization of excess earnings method, which is frequently used to value goodwill under the total value approach. Capitalization of total earnings is particularly likely to be rejected when its applied to a professional practice in a state where unrealizable goodwill is not divisible.
91
When will other courts consider this method?
Other courts have been willing to accept the method if the evaluator makes modifications to control the deficiencies (i.e. exclude the portion of owner’s annual income that represents reasonable compensation otherwise goodwill will include future earnings). Courts are more willing to use Capitalization of Total Earnings to value product oriented companies.
92
What is USPAP
Uniform Standards of Professional Appraisal Practice
93
What are the Approaches to Valuing a Business Under Uniform Standards of Professional Appraisal Practice (USPAP)
1. Net Asset Value or Adjusted Book Value – valuation of the assets only, which essentially is liquidation value
2. Income Approach – the discounted value of the projected future income stream
3. Market or Comparables – valuation based comparison of other comparable companies that have been sold on the open market.
94
What is the net asset value approach?
Net Asset Value or Adjusted Book Value – valuation of the assets only, which essentially is liquidation value
95
What is the income approach
The discounted value of the projected future income stream
96
What is the Capitalization of Earnings Method?
The Capitalization of earnings method begins by determining the annual net income of the business (i.e. gross revenue minus operating expenses).
97
How do you determine the net income of a business
gross revenue minus operating expenses
98
What is the first step in an income approach
First Step is to Normalize the Income. First calculation in the income approach valuation is you want to normalize the income.
99
What are typical manipulations in the income
Typical manipulations of the income steam included increases or decreases in officers’ salaries, changes in the company’s depreciation schedules (i.e. if the depreciation expense is higher, than the income stream is lower, so you check that the depreciation is not inflated), adjustments to the rental expenses, or increases or decreases in the cost of raw materials. If any of the expenses are adjusted upward, the income stream is lowered and the resulting value is lowered
100
What is the second step in the income approach
Second Step is to Determine Average Annual Net Income. Once normalizing the income to determine the annual net income of the business, the valuator will generally use an average net income over a period of 3 to 5 years, rather than from a single year alone.
101
What does the valuator sometimes do with the average income?
The average is sometimes weighted to give more weight to recent years.
102
Why does a valuator sometimes weight the average
A simple average of the last five years' earnings gives equal weight to each year, whereas the most recent results are more likely to reflect current business performance. Weighting the average net income is a way of giving more importance to the most current results
103
Explain or give an example of weighting
Step 1: List the company's net income figures for the last five years, starting with the current earnings.
Step 2: Multiply the earnings for each year by the weighting factor for that year. For example, a company's net earnings for the last five years are $150,000, $120,000, $90,000, $100,000 and $110,000. Multiply the current year's (Year Five's) earnings by five, Year Four's earnings by four, Year Three's earnings by three and Year Two's earnings by two. Year One earnings do not have a multiplier.
Step 3: Add up the weighted years and the total weighted earnings. In the example, the weighted years total 15 (5 + 4 + 3 + 2 + 1) and the total weighted earnings are $1,810,000.
Step 4: Divide the total weighted earnings by the weighted years to find the weighted-average five-year net income. Following the example, divide $1,810,000 by 15, which equals $120,667.
104
What is the third step in the income approach
Third Step is to Develop a Capitalization Rate.
105
What is a capitalization rate
A capitalization rate seeks to predict what rate of return an investor would require for the income stream based upon the riskiness of the company.
106
What is the most common method for developing a capitalization rate
The most common method for developing a capitalization rate is the build up method.
107
How does an evaluator arrive at the capitalization rate?
Risk Free Rate
Equity-Risk Premium
Size Premium
Company Specific Risk Premium
108
What is the risk free rate
Considered the safest and least risky investment available. You are looking at the return on Treasury Bonds
109
What is the objective of the risk free rate
Objective. Established by U.S. Treasury Bonds.
110
What is the equity risk premium
Riskiness of the Market in General (i.e. NASDAQ)
111
What is the objective of the equity risk premium
Objective. Established by annual publication
112
What is the size premium
Riskiness based upon Size of the Company (smaller companies are riskier)
113
What is the objective size premium
Objective. Published by Ibbotson yearbook.
114
What is the Company Specific Risk Premium
Risk applied on top of the 3 above
115
Is the Company Specific Risk Premium objective or subjective
Subjective
116
What does a higher capitalization rate mean
* Higher rate of return expected by investor
* Means a riskier company
* Renders a lower BV.
117
What does a lower capitalization rate mean
* Lower rate of return demanded by investor
* Means a less riskier company
* Renders a higher BV.
118
What should you consider in states that do not treat individual goodwill as marital property?
Caution must be used in applying capitalization of earnings to a business that benefits from the individual goodwill of the owner. If total net earnings are capitalized, the result will include the present value of earnings attributable to the individual goodwill, which is not marital property.
119
Why are capitalization earnings not often used?
Because of the individual goodwill problem, capitalization of earnings is not commonly used to value small service oriented businesses, such as professional practices.
120
Are taxes included when developing the income stream?
Taxes may or may not be subtracted.
121
In a Massachusetts case where the court subtracted taxes from the valuation, what was its rationale?
In Massachusetts case of Bernier v. Bernier, the trial court computed and used a hypothetical corporate tax rate which would result in the same net benefit to the shareholders as S corporation status. The reasoning was that while taxes may not be paid by the business in an S corporation, they are passed through to the shareholders and certainly paid by the shareholders.
122
In a Massachusetts case where the Court did not substract taxes from its valuation, what was the rationale?
In Massachusetts case of Adams v. Adams, the court held the direct capitalization of income methodology first determines the average normalized pretax income of a business entity
123
Why is there a concern that there is a double dip when value of a business is determined by capitalization of earnings?
The value of a business when determined by capitalization of earnings is the value of the entire business, including its intangible assets. If the court accepts a value based upon capitalization of earnings, and then adds the value of the business’ hard assets, it has counted the assets twice (i.e. the value of the dental practice already included the value of the bank accounts for the practice). However, if the expert capitalizes only the excess earnings, of the business, it must add the value of the business’ tangible assets
124
What is the Discounted Cash Flow (DCF).
This is the way companies are really bought today.
You earn x amount for the next 5 years and we will give you x percent.
You earn a projection over the next 5 years and you are going to present value that. How much will I make, and then I can determine the value. Usually you do over 5 years until then income normalizes and stabilizes. You want a stable income number. Then after this you multiple the capitalization rate.
125
What does the capitalization of earnings look at v the discounted cash flow
Capitalization of Earnings look at the past and the Discounted cash flow looks at the future. DCF is a guess and value is a forward looking concept.
126
What is most commonly used to value professional practices?
Capitalization of Excess Earnings
127
What is the Capitalization of Excess Earnings
This is most commonly used to value professional practices. It is a method for valuing earnings attributable to the goodwill, not attributable to a voluntary decision to work longer or harder.
For example, you look at the average of earnings of another business under similar conditions and subtract it from the average earnings of the owner’s business, and the excess earnings is the result of the calculation. The excess earnings are then capitalized—divided by a percentage or multiplied by a factor. After applying the method, the valuator must then add the total net tangible assets (assets less liabilities) of the business for the value.
128
What do you do first for Capitalization of Excess Earnings
You first compute the annual net income of the business the same as you would under the capitalization of earnings method. Also, fringe benefits, such as business funds spent to pay personal expenses of the owner, should be included. Reasonable operating expenses, including a fair and reasonable salary of the owner must then be subtracted. Unreasonably excessive operating expenses should not be subtracted. After computing the actual average net income of the business, the evaluator computes the average earnings of a similarly-situation business (i.e. a business ideally operating in the same state, if not the same local community). Average earnings are most frequently drawn from statistical surveys of incomes earned by businesses or practitioner
129
What is the next step in the Capitalization of Excess Earnings
The excess earnings are then capitalized—divided by a percentage or multiplied by a factor. The evaluator considers the same series of points that are considered under the capitalization of earnings method. There is some authority that a factor of 3 or a percentage of 33% should be regarded as a starting point
130
What are intangible assets that should / could be considered in the value?
Intangible assets such as contracts, website domain, location, how long business been around, trademarks owned by company, phone numbers, patents, etc.
131
What approaches might you consider the intangible assets?
These are intangible assets that businesses can own and make up the value from the NAV and the Income Approach Value. So while there may be no value on the books of what a patent is worth, you want to do the analysis of what this is worth
132
What is EBITDA
Earnings
Before
Interest
Taxes
Depreciation
Amortization
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When does EBITDA comes into place?
EBITDA comes into place with Income and Comparables so you need to know this. You are normalizing income to get to the true EBITDA. This is when you do the exercise you do to normalize the income. (he should be paying himself less salaries, expenses, paying rent, wife is on the books, nonrecurring expenses, divorce expenses). What are the true expenses to generating that income.
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What does working capital refer to?
You need to buy equipment every year. You need to put reserves away for painting building. You refer to this as working capital. You may need this money to buy this
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In service types business, when do you recognize income and expenses?
You recognize revenue when you receive it. You recognize expense when you pay it, not when it is due.
