How Financial Statements Can Be Used to Value Private Businesses

Owners of private businesses often wonder: How much is my business interest worth? Financial statements are a logical key starting point for answering this question. Here’s an overview of how financial statements can serve as the basis for value under the cost, income and market approaches.

Cost approach

Because the balance sheet identifies a company’s assets and liabilities, it can be a good place to start the valuation process, especially for companies that rely heavily on tangible assets (such as manufacturers and real estate holding companies). Under U.S. Generally Accepted Accounting Principles (GAAP), assets are recorded at the lower of cost or market value. So, adjustments are often needed to align an item’s book value with its fair market value.

For example, receivables may need to be adjusted for bad debts, inventory may include obsolete or unsalable items, and contingent liabilities — such as pending lawsuits, environmental obligations, and warranties — also must be accounted for.

Some items may be specifically excluded from a GAAP balance sheet, such as internally developed patents, brands, and goodwill. The value derived from the cost approach omits an intangible value so that this estimate can serve as a useful “floor” for a company’s value. Appraisers typically use another technique to arrive at an appraisal to reflect the value of the company including these intangibles assets.

Income approach

The income statement and statement of cash flows can provide additional insight into a company’s value. Under the income approach, expected future cash flows are converted to present value to a business’s value.

Reported earnings are often adjusted for a variety of items. Examples of items that may require adjustments include depreciation, market-rate rents, and discretionary spendings, such as owners’ compensation or nonessential owners’ travel expenses.

A key ingredient under the income approach is the discount rate used to convert future cash flows to their net present value. Discount rates are made up of multiple factors and will vary based on an investment’s perceived risk in the marketplace.

Market approach

The market approach derives value primarily from information taken from a company’s income statement and statement of cash flow. Here, pricing multiples (such as price to operating cash flow or price to net income) are calculated based on the sales of comparable private companies or public stocks.

When looking for comparables, it’s essential to filter deals using relevant criteria, such as industrial classification codes, size, and location. Adjustments may be required to account for differences in financial performance and to arrive at a cash-equivalent value, if comparable transactions include noncash terms and future payouts, such as earnouts or installment payments.

Independence and experience count

Business value is a critical metric, whether it’s used for financial reporting, M&A, estate and tax planning or litigation purposes. Basing a major decision on a do-it-yourself appraisal can be costly. Contact us for help calculating an estimate of value that you can count on.