The value of a business is a question on many business owner’s minds. Whether the owner is considering retirement, estate planning, succession planning, reviewing buy/sell agreements or possibly selling, it is important to know what a business may be worth. Considering these issues, business owners will generally question, what is my business worth, what provide value to a business or what can I do to increase value?
One of the first things to know about the business’s value is that no specific valuation method will be 100 percent precise, and each method can present a different result depending on the purpose of the valuation and the methodology utilized. In general, a company’s value is everchanging, and it is essential to understand that a valuation at a specific point in time may not apply to the current point in time. The fundamental concept for business owners to recognize before consulting with a valuation expert is the difference between the book and fair market value.
Book Value
- Book value is an easy concept because it is the value recorded on the company’s books. By taking the total of the company’s assets and subtracting the outstanding liabilities, the remaining amount is book value of equity.
Things to Consider:
- Book value is an accounting term and is not affected by a change in the market. Even though a company may be depreciating its assets under Generally Accepted Accounting Principles, it may not reflect how an asset’s value changes. Heavily used vehicles are an example of how book value may be different than market value. Vehicles will generally depreciate faster than the 5-year period assigned for accounting, especially if used in construction or other industries that require heavy usage.
- Book value may also not accurately consider the impact of debt on its assets. The book valuation may be different from the real value if the company is under economic distress or bankruptcy.
- The book value is not a useful tool for businesses heavily dependent on human capital. Human capital provides an intangible value that is not reflected on the books. A company may have great people in management or relationships with customers tied to specific individuals working at the business.
- Book value does not take into consideration the goodwill or blue sky of a business.
- One of the major issues with book value is the value is based on a specific point in time. Usually, this value would be calculated on a quarterly or annual basis to coincide with financial statements or a tax return. As discussed above, a specific point in time may not reflect the company’s current fair market value.
- Example: Consider the effects of the COVID-19 pandemic on a company. A company’s book value at the end of February 2020, in many instances, would be substantially different than at the end of March 2020.
Fair Market Value
- This type of value is what your business is likely to sell for on an open market. When a company has a business valuation performed, they are looking to determine the fair market value of their business. If a business is planning on selling, this is a good starting point to set potential buyers’ prices.
- Many view fair market value in terms of the publicly traded stock market(s). Whatever price a company’s stock is trading at on any given day or time would be considered the fair market value. Because ownership in smaller private companies is not bought and sold on a day-to-day basis, fair market value must be determined by other methods. Three generally accepted valuation methods used to determine fair market value are:
- Asset approach
- Income approach
- Market approach
Each method will most likely result in a different value of the company for a set point in time. All three ways use actual financial information from the company. From there, adjustments may be made to assets and liabilities or income and expenses on the company’s books to reflect the fair market value or represent normal operations.
While a business valuation is useful in setting a starting value in negotiating a sale, the fair market value will ultimately be reached upon its sale.
Things to Consider:
- Determining fair market value in a business valuation for small private companies is derived from publicly traded companies’ data.
- The risk related to return on investment is not guaranteed, and a company’s earnings potential may be greater or worse than the value the company was purchased for.
- Fair market value is greatly affected by the economic environment at the time an asset or company is sold. The cost of sale today may not be worth the same tomorrow.
Book vs. Fair Market Value
If fair market value is less than book value, it is an indication that the market does not view the company as valuable as the financial statements report. It may be due to economic distress, pending lawsuits, or internal business problems. As a result, a potential investor does not believe the assets will produce a return on investment that the book value indicates. In terms of risk, investors might seek out companies in this category in hopes that the market indicators are incorrect, and the subject company will generate greater returns at a discounted price.
If fair market value is greater than book value, the market indicates the company is worth more due to the potential of earning power. This may be due to economic growth, plans for expansion, or increased profits that will increase book value in the future. A profitable company will generally have a fair market value greater than its book value. On the other hand, a market value greater than a book value may also indicate a company is overvalued and subject to change in the unforeseen future.
Questions about Book Value vs. Fair Market Value?
There are many reasons a company may want or need a business valuation, including:
- Negotiating a merger or business sale
- Estate and gift tax planning
- Considering new shareholders
- Attempting to resolve partner or other liability disputes
- Determining shareholder equity
- Marital dissolution
A business valuation may also be useful for strategic planning and benchmarking purposes. Whatever purpose the valuation is fulfilling, it is vital to engage experienced professionals who will take a comprehensive view of all the company’s investments. Contact Smith Schafer’s Valuation Services Group to schedule a consultation.
