How to Establish the Fair Market Value of a Company
If you are considering the purchase of an existing business, you will need to come to an agreement with the seller on the purchase price.
The "fair market value" of a company, or share of a company, is the price that both buyer and seller agree is fair. The seller wants to extract as much value from his investment as possible, while the seller wants to pay as little as possible. How can you agree on the fair market value?
Realize that the "fair market value" is not the same as the "book value." The fair market value is typically (though not always) higher than the book value.
Why is this? The book value represents the company's tangible assets, minus the liabilities, as recorded in the company's accounting books. Isn't this a "fair" value?
In most cases, no. This is because many assets are written off or depreciated, or may be held at the original purchase price. In reality, however, such assets may have appreciated in value. One example of this is the building from which the business operates.
Also, an existing company often has large intangible assets that are not captured in the books but which substantially impact the future earnings and profit potential of the firm. These may include patents, licenses, goodwill, or other factors.
There are many methods of valuing a business. One of the least complicated and most widely used methods is the "Sales Multiple" method.
The sales multiple method of valuation consists of applying a multiplier to the company's annual sales. The appropriate multiplier to use depends on the industry, and can range anywhere from 0.25 to two times the sales figure. The multiplier takes into account factors like intangible assets and equipment that are typical for a given industry.
You may wish to use a spreadsheet program to help you make these calculations.
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Things You'll Need
- The firm's financial statements for the past 3 to 5 years
- Data on typical businesses in the industry and geographical area
- Data on the recent valuation of comparable companies, if available
- Data on local and regional market conditions
- Spreadsheet software or specific business valuation software
Instructions
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Sales Multiple Valuation
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Identify the correct sales multiplier for the type of business you are considering. Sources for this data can be found using our Resource links.
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Identify the previous year's total annual sales on the financial statements.
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Apply the correct industry multiplier to the business's annual sales figure.
Note: Pay close attention to the factors included in your source's multiplier. You may need to add or subtract the business's tangible assets or liabilities to arrive at a final valuation.
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Add or subtract, as appropriate, the firm's tangible assets or liabilities. These include items such as the firm's cash, accounts receivable, and real estate.
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Check your sales-multiple valuation against recent valuations of comparable firms.
Note: If your sales-multiple valuation is similar to recent comparable transactions, then you have probably reached a reasonable fair market value.
If it differs, double check your assumptions and calculations. Once you're confident of your calculations, you'll want to understand the factors that are driving the difference. These may include regional economic or demographic factors.
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Set up a meeting with the seller to discuss your valuation. Be prepared for some negotiation. If you and the seller can reach agreement based on your valuation, then congratulations! You have established a fair market value for the company.
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Tips & Warnings
When you first approach the seller, try to implement an agreement to find an informal fair market value. You can resort to a formal appraisal later if you cannot come to an informal agreement. But if you can achieve an informal agreement, you'll save both time and money.
Maintain an objective outlook. Strong emotions can come into play when considering the purchase of a business, but to make the best decision, rational judgment is needed.
An impartial expert can provide a sanity check. Should you choose to hire one, your professional adviser can help you avoid making a big mistake.
Have a range of prices in mind which you would find acceptable.
Do not be discouraged if it takes more than one attempt before a final fair market price can be agreed upon.
The accurate estimation of a company's fair market value is as much an art as a science. You may want to consider seeking the opinion of a CPA, lawyer, or business broker who is experienced in business valuation. Such a professional will be able to give careful consideration to the detailed factors in your specific case. At the same time, you will receive the benefit of his expertise from previous transactions.
