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Valuation gives business essential planning tool

Posted online

by John Qua

for the Business Journal

The environment in which many businesses operate today is changing at an increasing rate. Therefore, many of the decisions you make regarding your business can have a significant impact on its value, and accordingly, on your personal net worth.

Understanding the value of your business and the impact major business decisions have on its value should be a critical first step in any business planning process. In addition, there are many situations which require you to have an accurate knowledge of your business's value:

?Preparing a personal estate plan or a business succession plan.

?Contemplating the sale of a division or your entire company.

?Purchasing the stock of shareholders desiring liquidity.

?Acquiring another company, or changing your company's strategic direction.

?Planning for future growth or restructuring your business's debt.

Many business owners may depend on general rules of thumb or comparisons with competitors to estimate the value of their business. However, many crucial financial decisions can hinge on an accurate assessment, so it makes sense to have a professional business valuation. With it, you will have the information you need to enhance its value today and in the future.

Valuation methods.

Determining the market value of a privately held business is a complex task. Many variables can affect a company's value, such as general economic conditions, public market conditions for specific industries, level of merger-and-acquisitions activity, a company's earning history and future earnings capacity, the balance of risk and reward, and qualitative factors (reputation and goodwill).In addition, if you are considering selling shares of your business, the value of your business equity will depend on whether you are contemplating the sale of your entire company, partial liquidation, an employee stock ownership plan, or another arrangement.

Discounts or premiums may apply to the business value depending on what percentage of interest in the company is being offered, as well as the attractiveness and potential liquidity of the investment.

A professional valuation of an ongoing business is determined by using one of the following basic methods:

?Market compar-ables. The use of market comparables estimates a business's value based on market prices as indicated by stock prices for similar public companies. Value is established through analyzing earnings multiples for recent stock trades of comparable businesses.

This approach provides an estimate of value by calculating average price/earnings multiples of comparable public companies. By adjusting for differences between public and private companies, a final value is computed.

The downside to this method is that a reliable comparison can be difficult to draw, because other public companies in your industry may be larger than your own company, or differ in their business description.

?Merger-and-acquisition comparables. A similar method to the market comparables is to estimate a business's value based on actual merger-and-acquisition transactions that have occurred for similar companies.

The merger-and-acquisition comparables method is typically used to value majority or controlling interests in a company by analyzing purchase-price multiples of recent acquisitions or mergers of similar companies.

Again, differences between the company being valued and the acquired companies are taken into account by examining factors such as size, growth rates, profit margins, and depth of management.

The downside to this method is that it is often difficult to obtain data on comparable transactions, particularly with private companies where disclosure of purchase price data is not required.

?Discounted cash flow. The use of discounted cash flow follows the premise that a prudent investor would pay no more for a business than the present value of its future cash flows. Value is based on the future cash flows a business is expected to generate from operations, discounted to a present value by an appropriate risk-adjusted return rate.

A valuation professional will analyze a company, recast its financial statements, if necessary, to eliminate expenses not related to operations, project after-tax cash flow into the future and develop a discount rate that factors in the appropriate level of risk of the company.

One drawback to this method is that calculations are made based on projected performance, which may be either too optimistic or too pessimistic.

A starting point.

As a business owner, you should have an independent valuation performed to determine the economic impact your management decisions are having. Depending on economic conditions or your individual situation, you may need to have the valuation updated on an annual basis.

A professional valuation can provide an analysis of the economic factors affecting your business, as well as a detailed comparison of your firm with others in your industry, by outlining the current strengths and weaknesses of your company.

Using this information, you may decide to change aspects of your business, such as your facilities needs, employee benefits, product line, manufacturing and distribution process, or management team.

An accurate and professional valuation of your business puts you in a better position to accomplish your business's financial goals. Talk with your business advisor to find the valuation professional that fits your business's needs.

(John Qua is senior vice president and director, Business Financial Services, for Merrill Lynch.)

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