This overview can help you understand the approaches, methods and factors important to valuing your business
Revenue Ruling 59-60 was issued by the IRS to “outline and review in general the approach, methods and factors to be considered in valuing the shares of the capital stock of closely held corporations for estate and gift tax purposes.” This revenue ruling is regarded as the foundation of modern business valuation, and although issued sixty years ago, the approach, methods and factors set forth therein are still used in every business valuation, including valuations of business entities other than corporations.
Revenue Ruling 59-60 lists the following eight fundamental factors that require careful analysis in each case.
- The nature of the business and the history of the enterprise from its inception.
- The economic outlook in general and the condition and outlook of the specific industry in particular.
- The book value of the stock and the financial condition of the business.
- The earning capacity of the company.
- The dividend paying capacity.
- Whether or not the enterprise has goodwill or other intangible value.
- Sales of the stock and the size of the block to be valued.
- The market price of stocks of corporations involved in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter.
Approaches to valuing a business
The three basic approaches in valuing a business are the asset approach, the income approach, and the market approach. The factors listed above include the analysis required to value a business under each of these approaches.
Under the asset approach, the value of the business is the value of the net tangible assets. This method does not consider goodwill or other intangible assets and is most commonly used in the valuation of real estate entities. This method may also be applicable to unprofitable businesses and those in or close to liquidation.
The market approach consists of two methods, the guideline public company method and transaction method. Under the guideline public company method, the financial attributes of the subject company including but not limited to sales, earnings, cash flow, total assets, net book value are compared to the same attributes of publicly traded companies in the same or similar industries, and with fairly complex analysis, the value of the subject company is determined by comparison to the stock price of the publicly traded company. This method is generally not applicable to small businesses because they are not usually comparable to publicly traded companies, even those in the same industry.
Under the transaction method, the value of the subject company is determined based on analysis of and comparison to the financial attributes of similar companies that have sold in private transactions. This method is used when there are enough comparable transactions, and enough financial information about these transactions is available.
Under the income approach, a measure of income (generally normalized cash flow) is capitalized or discounted to estimate the value of the company. Capitalization is used for historical cash flow; discounting is used for projected cash flow. The capitalization rate is based on risk, that is, the risk that the expected cash flow will not be realized. Common closely held business risks considered in this process include customer or supplier concentration or diversification, depth of the management team, product obsolescence, prospective competition, and the state of the industry in which the company participates.
Learning more about business valuation
This is a ten-thousand-foot view of business valuation. Future posts will provide detailed information of things discussed here. Many of the factors considered are controllable, and factors reducing business value can often be improved. Those who are considering the future sale of a business and want to maximize its value should start thinking about this now. If you wait until you are ready to sell, that is usually too late. The first step is to understand the current value of the business, and what are the factors driving that value. After that, the valuation can be periodically updated, which will be a gauge of progress in increasing value.