You’ve built a great business and now it’s time to start thinking about retirement. So what is your privately-held business worth? There are three approaches to valuing a closely-held business: Asset, Income, and Market. The Income Method is often the best approach for valuing an operating business, so let’s take a closer look at that method.
Focus on the Income Statement
This method starts with Net Income on the Income Statement, then adds back things like the following:
- Non-cash expenses like depreciation or amortization.
- Non-operational expenses like a hunting lodge, season tickets to your favorite pro team, or excess rent paid to a related entity.
- Non-recurring expenses for things like a marketing consultant or 10 year anniversary celebration.
- Discretionary expenses (perks) like club dues, company car, or insurance offered only to the owners.
- Excess compensation paid to owners
The result of these adjustments is the Cash Flow to Equity owner(s). Now subtract federal income taxes to arrive at Cash Flow to Equity after Taxes. Finally, divide by the appropriate capitalization rate (risk rate or cost of capital) to arrive at the total Business Value. It’s best to use an average of the last 3 to 5 years of cash flow to smooth out any year to year variation.
There is also a variation of the Income Method that uses a discounted future earnings stream. It’s still an income focus, but it is looking forward rather than using historical earnings.
The concept is simple, but the steps may be a little confusing. If you have questions call your Business Valuation Professional.
Next time we will take a look at the Market Method.