Business Valuation Example

Many factors influence the purchase price of a small business. Market value of the assets,goodwill,location and competitors are all considerations in determining a purchase price.Several valuation techniques should be used to create a "valuation curve." Below are some analytical methods of small business valuation, however, the utility (or lack of) associated with location, competition, and other industry specific factors should be considered when assessing the Risk Premium.

Business Valuation Approaches
Shaded cells are subjective per each evaluation and are the ONLY values that need input.

Target Company Balance Sheet
		Book	Fair Market		Book
		Value	Value		Value
Current assets		175000	187500	Current Liabilities	75000
Investments		75000	87500	long-term Debt	100000
Property & Equipment		400000	500000	Capital Stock	75000
				Add'l Paid-in Capital	225000
				Retained Earnings	175000

Total Assets		650000	775000	Total Equities	650000

Determine normal Return on the Fair Market Value of Tangible Assets
The normal return on assets within the target industry.

Total Assets (FMV)			775000
Less: Liabilities			-175000
Net Assets (FMV)			600000
Normal Rate of Return			0.18
Normal return on
FMV of Tangible Assets			108000

How to determine an appropriate capitalization rate.

Long-term US Gov't Bond Rate				6%
Plus: Avg. return on small stocks
over US Gov't Bonds				8%
Expected return on small stocks				14%
Plus: Risk Premium				5%
Total expected rate of return				19%
Less: Long-term Inflation expectations				-4%
Small Business Capitalization Rate				15%


Determine future earnings based on past years performance.

	Net
Past	Ordinary		Determine Average Excess Earnings
Years	Income		This method ignores the time value of money.
1	122000
2	119000		Average Earnings	121600
3	120000
4	123000		Normal return on
5	124000		FMV of Assets	108000

Total	608000		Excess
Average			Earnings	13600
Earnings	121600

Compute Goodwill
The lower the capitalization rate, the higher the value of Goodwill.
The higher the risk premium, the lower the value of Goodwill.

			Value of
Excess		Capitalization	Excess
Earnings	divided by	Rate	Earnings

13600	divided by	0.25	54400
13600	divided by	0.15	90667
Company Valuation - Excess Earnings Approach
Assumes excess earnings will last indefinitely.
Assumes a consistent normal return on FMV of Assets.

			25%	15%

Net Assets (FMV)			600000	600000
Value of Excess Earnings
over 18% ROR on Net Assets
@ 25% Capitalization			54400
@ 15% Capitalization				90667

Estimated Company Value			654400	690667

Company Valuation - Present Value of Excess Earnings Approach
Assuming 15 years of excess earnings.
Excess Earnings:			13600

Applicable discount rate:			15%

	Expected		Present
	Net		Value of
Future	Ordinary		Expected
Years	Income		Cash Flows
1	13600		($11,826)
2	13600		($10,284)
3	13600		($8,942)
4	13600		($7,776)
5	13600		($6,762)
6	13600		($5,880)
7	13600		($5,113)
8	13600		($4,446)
9	13600		($3,866)
10	13600		($3,362)
11	13600		($2,923)
12	13600		($2,542)
13	13600		($2,210)
14	13600		($1,922)
15	13600		($1,671)
Estimated Present Value of
Average Excess Earnings			$79,524

Plus: Net Assets (FMV)			600000

Estimated Company Value			$679,524

Company Valuation - Average Earnings Approach
Assumes consistent returns on Averaged earnings only.

			25%	15%

Average Earnings			121600	121600

Value of Average Earnings
@ 25% Capitalization			486400
@ 15% Capitalization				810667

Estimated Company Value			486400	810667

Company Valuation - Present Value of Average Earnings Approach
Assuming 15 years of Average earnings.

Average Earnings			121600

Applicable discount rate:			15%

	Expected		Present
	Net		Value of
Future	Ordinary		Expected
Years	Income		Cash Flows
1	121600		($105,739)
2	121600		($91,947)
3	121600		($79,954)
4	121600		($69,525)
5	121600		($60,457)
6	121600		($52,571)
7	121600		($45,714)
8	121600		($39,751)
9	121600		($34,566)
10	121600		($30,058)
11	121600		($26,137)
12	121600		($22,728)
13	121600		($19,763)
14	121600		($17,186)
15	121600		($14,944)

Present Value of Average Earnings Approach			$711,040



Company Valuation - Present Value of Expected Cash Flows
Determine future earnings based on *expected annual growth*.
Expected annual growth rate:			2%

Current net ordinary income:			122000

Applicable discount rate:			15%

	Expected		Present
	Net		Value of
Future	Ordinary		Expected
Years	Income		Cash Flows
1	124440		($108,209)
2	126928.8		($95,976)
3	129467.38		($85,127)
4	132057		($75,504)
5	134698		($66,969)	$431,784.51
6	137392		($59,398)
7	140140		($52,684)
8	142942		($46,728)
9	145801		($41,446)
10	148717		($36,761)	$668,801.08
11	151692		($32,605)
12	154725		($28,919)
13	157820		($25,650)
14	160976		($22,751)
15	164196		($20,179)

Estimated Company Value			$798,905


Valuation Curve

Excess Earnings Approach				690667
Present Value of Excess Earnings Approach				679524
Average Earnings Approach				810667
Present Value of Average Earnings Approach				711040
Present Value of Expected Cash Flows				798905

			Total	3690803
			divided by	5
Average of Company Valuations				738161

Kenneth M. Rumberger

adviser@strategicaccounting.com

Independent Accountant & Florida Real Estate Broker

Last Updated on 11/23/1999
By Kenneth M. Rumberger