what is it worth?
Determining the value of a company in the green industry can be a complex matter. Individuals examining the financial statements of a green-industry company can draw different conclusions as to the value. Frequently, an experienced business appraiser, after examining all of the varying conclusions about the company's value, may conclude that each value is correct. The reason many professionals can determine the value of a business differently is that each defines “value” differently. Let's examine the traditional approaches to value that are typically used when valuing a business.
Value is an imprecise term because it varies with the situation.
Fair market value is the most common definition of value. It is the definition used when determining a value for estate and gift tax purposes. Revenue Ruling 59-60 defines fair market value as: “…the amount at which the property would change hands between a willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”
Fair value is a court-determined value provided for under some states' laws. In those states, if a corporation agrees to a merger, sale or other action and the minority stockholders believe they will not get adequate consideration for their stock, those shareholders have the right to have their shares appraised and get fair value in cash. In some states, fair value may be used to determine the value of stock in a divorce case.
Investment value is the value of an asset or business to a specific owner or prospective owner. This type of value considers the owner's or prospective owner's knowledge, abilities, expectations of risks and earning potential and other factors. Some people consider intrinsic value to be the same as investment value. Other professionals consider intrinsic value to be a value based on the analysis and judgment of an independent security analyst, investment banker or financial manager.
The definition of value, the purpose for the determination of the value and the type of ownership interest will affect the valuation methods used to value an enterprise. The value of a business is equal to the present worth of the future benefits of ownership. Thus, the sale of a business will only occur at an amount equal to the benefits of ownership. Because the determination-of-value process is full of judgments and estimates, no one can predict with certainty the benefits a future owner of a business will receive. Value, though it is not a specific amount, it is based on a specific point in time. In the green industries, value is erratic due to the type of services sold or products offered in the market. Further, it is difficult to predict profits from year to year for many green industry companies. These factors all increase the variability in the determination of value.
Approaches to value determination
Because a company's value is derived from its future benefits, those benefits cannot be measured with certainty. Green industry companies have different risks and earnings characteristics; thus, no single formula can be used to determine the value of every company in every situation. A business appraiser will use different approaches and methods for estimating future benefits and companies' values.
The types of valuation methods used to determine the value of a green-industry company may be calculated using the income approach, which can be based on the capitalization of current income or on discounted future returns (projected future income).
In cases where the income approach is not applicable, it may be necessary to estimate the value of the business based on looking at other companies in the green industry. Using the industry approach to determine the value is know as the market approach to valuation. When neither of these two approaches is applicable, the best indication of value may be determined from the underlying assets of an enterprise, also known as the asset approach to valuation. Each of these approaches to the valuation of a green-industry company are considered by an appraiser, and the approach to value that the appraiser deems most reflective of the value of the enterprise is the one presented in an appraisal report.
But what if you want to estimate the value of your company? How could you apply these approaches to value?
Determining the value of your green-industry company
- Market approach
One of the easiest methods of estimating the value of a green-industry company is by applying the market approach. This approach says that a company's value can be determined via a price-to-earnings (earnings are after-tax earnings) multiple, such as 4 times earnings. The weakness of this approach is that not all companies have the same risks associated with their operation across the country. Thus, this multiple concept may not be right for a company in a large city compared to a smaller-market company. An example of the application of this market approach to calculating the value of a company can be seen in Table 1 (above), where the value of the company was determined to be $1,180,000.
- Income approach
The income approach to value looks at the profitability of the green-industry company. Many company owners seek to minimize profits so as not to pay taxes. Thus, determining a company's true value based on its profitability can be a challenge. For an owner to determine its value, expenses that are not applicable to the operation of the company in the current year are removed (this is known as normalizing the performance of the company) and the adjusted profitability of the company is then used to determine its value.
Often, normalized profitability becomes the basis for an appraiser to use to determine the future profitability of the company. Projecting the profitability of a specific company for five or six years into the future involves an assessment of the risks of the company being successful in achieving the profitability projections developed. An example of the application of this income approach to calculating the value of a company can be seen in Table 3 (above), where the value of the company was determined to be $1,290,000.
- Asset approach
The asset-based approach to valuation examines the assets and liabilities of a company that are adjusted to its appraisal value. The book value of a company's assets may not be reflective of its current market value. This approach to valuing a green-industry company is applied when companies that perform one-time service — such as landscape, irrigation or lighting system installation — are evaluated. An example of the application of this approach to calculating the value of the company is shown in Table 2 (page 16), where the value of the company was determined to be $776,549.
Risks that vary by company and the competitive nature of the green industry create uncertainties that need to be factored into a company's valuation. As the owner of a green-industry company, becoming familiar with the factors that create value for your green-industry company is critical. Knowing the factors that drive value for your company is helpful in determining the course of business you pursue and the level of profitability that should be achieved on varying types of service. When revenue does not translate into long-term value, profit in the current year above the market place is critical.
Determining the value of a green-industry company takes time and requires an experienced industry professional knowledgeable of the uniqueness of the industry and the specifics of the company. Potentially, an accurate and appropriate determination of value has great financial consequences, so do not hesitate to contact an attorney or accountant with experience in such matters.
Ed Wandtke, CPA, CVA, MBA, is a principal in Wandtke & Associates (Columbus, Ohio), which specializes in management consulting in business valuation, marketing and training. Wandtke does business valuation for buy-sell, estate, tax planning and divorce for green-industry companies. He can be reached at (614) 891-3111.
Want to use this article? Click here for options!
© 2016 Penton Media Inc.