In every small businessman’s career there comes a time when thoughts must be turned to an exit strategy. That is, what is the end game? How will you cash out? Will you cash out? Will you leave your business as an inheritance to children or other family members? Whatever the plan or strategy for moving out of your business, it is critical that you have an understanding of what your business is worth.

There are a number of different methods for valuing a business. This blog represents the first of three blogs intended to entertain a high-level discussion of three commonly used valuation methodologies: Cost, Discounted Cash Flow and Price/Characteristics Ratios. The Cost Methodology will be discussed first.

The cost method of valuation involves two steps. First the business owner or hired consultant must assess the cost to replicate existing assets.
There are four ways to determine the replacement value of existing assets. The method chosen depends on the nature of the assets and the reason for the valuation.

1. Book – The book method is relatively straight forward and would be accomplished by taking the value of assets from the balance sheet less accumulated depreciation. Any good accountant should be able to help with this relatively simple approach. The book value method would be most effective if the business was recently purchased, thus the assets would theoretically reflect current market values.
2. Adjust Asset – The adjusted asset method requires analysis of each asset on the balance sheet and would be helpful if book values are significantly different than market values. With this approach the consultant would take the book value of say a piece of land. He would then assess the market value of the land and adjust the book value to reflect current market values. This approach can be very time consuming.
3. Liquidation – Similar to the adjusted asset method, the liquidation method seeks to understand the value of each asset. However, with the liquidation method the consultant is not concerned with market value rather contingent, contingent on bankruptcy, value. This approach may be most likely used by a banker to determine what the value of a business’ assets would be if the business were to go bankrupt. Value determined by this approach will clearly be less than adjusted value.
4. Replacement – This method of determining replication cost seeks to ascertain the required cost to replace existing assets using current technology. For example if a high-tech manufacturer has an existing plant that it built 5 years ago for $1.0M but, with technological advances could build the same plant for $0.8M, the building would be valued at $0.8M. This approach of determining replication value would be best used in industries where technology has dramatically changed the cost to replace assets.

The second and final step of the Cost method is to assess the value of a company’s intangibles. Intangibles might include brand recognition, favorable relationships with clients or customers, experience and knowledge. Not all intangibles are positive. For example a pending lawsuit would be a negative intangible. After all intangible values are assessed they can be added or subtracted from total replication cost to determine the Cost of the business.

Due to the subjectivity and difficulty of determining the value of intangibles and at times the inability of accurately determining the value of fixed assets, the cost approach should be used with some hesitation. But at the same time can serve as a good exercise to understand the true value of company assets.

Richard Zollinger is a finance manager at American Express.

This entry was posted on Friday, August 17th, 2007 at 8:34 am and is filed under Finance, Leadership. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.