The Tien and Jim Approach to Fair Market Valuation
Although there are many variations of ways to estimate the value of a business, they tend to group within three possible approaches:
Asset Based Valuation
Market Comparison Valuation
Income Based Valuation
We use the most commonly used (and most appropriate valuation) approach for a small business (defined as a business with annual sales of $5 million or less); an Income Based Valuation. The Income Based Valuation approach is further broken down into four generally accepted methods:
Present Value of Future Earnings
Gross Revenue Multiples
Capitalization of Excess Earnings
Multiple of Discretionary Earnings
The valuation method we use is a combination of both the widely used and professionally accepted Capitalization of Excess Earnings method and the Multiple of Discretionary Earnings method. This is a powerful way of estimating the value of a business that allows it to be fairly valued as an investment opportunity without many of the uncertainties that other valuation methods introduce. This method assumes that business owners are entitled to a fair return on the value of the business (their investment) over and above their fair wage (if the owners work in the business). This combined approach will assign a financial value to the Companys reconstructed earnings (resulting in available discretionary earnings) that is reflective of the risk associated with the continued operation of the business with recent proven financial results that can reasonably be expected to continue after the business sale for an indefinite but substantial duration.
Using the two valuation methods described above also allows us to calculate the Goodwill value in the business as well as its estimated fair market valuation. This approach works equally well whether the business to be purchased is operating as a sole proprietorship, partnership or as a corporation.
The fair market valuation methods used by us are based on the income a business has proven it can earn. The expectation will be that the recent level of actual earnings of the business will continue at or above that level for some reasonable period of time, at a minimum. The estimated fair market value of the business based on its proven earnings will be strongly affected by applying a factor (a return on investment multiplier/capitalization rate) for the projected risk associated with new ownership.
Calculation of a multiplier/capitalization rate for a business valuation can be a long, complicated and confusing procedure using traditional methods.
Fair market value is defined as the price at which a business would change hands between a willing and knowledgeable buyer and a willing and knowledgeable seller, both acting upon complete and accurate information.
In considering the potential fair market value of a business its also important to make an assumption about the most likely type of buyer. The Tien and Jim approach assumes that the type of buyer will be either:
A financially motivated/investment-oriented buyer (generally a private individual or group), or
a strategic buyer (another company wishing access to one or more of the key company assets for expansion purposes)
It should be noted that the approach used in this pro-forma is not as rigorous as a professionally developed business appraisal by an accredited professional, which may cost thousands of dollars. For example, two valuation methods are used here where a professional valuation may use several approaches and compare/consolidate the results. Also, our approach is intended for use with financially motivated (investment oriented) or strategic buyers who comprise the vast majority of potential buyers of a business. Other reasons for business valuation such as ESOP purchases, estate planning, adversarial marriage/partner dissolution, may be better served by other valuation methods.
We will use your financial data to calculate two key variables to obtain a good estimate of the fair market value of a business:
1. A projected weighted-average available cash flow (ACF) based on a reconstruction of the last three years of financial operating data.
2. A multiplier (return on investment/capitalization rate) to apply against the projected ACF based on the risk factors/investment considerations in the business.
These two variables will be used to determine the fair market value (FMV) of the business as follows:
FMV = (ACF x Multiplier) + Current Asset Value (to be included in the sale) + Real Estate (if applicable) Liabilities (to be assumed)
Tien and Jim
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