Valuing a Business That Has No Future
By Shawn M. Hyde
“The value of an operating business is based on its expected future earnings.”
That is the line I hear most often when discussing how to determine what the fair market value of an operating business is. It is a very specific and simple description of a formula that many of us first came across in a finance class in college.
The main problems business appraisers have, are determining what those variables (income and risk) actually are. Once those problems have been solved, then the rest of the analysis generally flows pretty well from there.
In one of my recent assignments, I discovered something in the middle of my analysis. The subject business did not have any expected future earnings. The risk of achieving $0.00 is pretty low, but the formula returned an answer that I did not believe accurately reflected the value of this business.
The inventory was not booked accurately.
I turned to the adjusted net asset method. I looked at every single asset and liability reported on the balance sheet as of the effective date. I spoke with management, examined financial statements, and did some research. The Company expected to receive some of the outstanding AR, but the inventory was booked at a much higher number than it was actually worth.
Part of this was due to inaccurate bookkeeping on the part of my client, but the other part was that there were not many potential buyers out there who would consider purchasing the inventory either. The equipment list had not been updated for about eleven years and included several items that had broken down and had been thrown away, as well as some pieces that had been used for their parts to fix other items.
The liabilities side of the balance sheet suffered from similar problems.
I found a ‘loan’ that actually was no such thing, but that is how the owner had been tracking his rent payments. I found several IRS notices that described taxes and penalties owed that had not been tracked on the balance sheet. The one outstanding loan that the business had was showing a wildly incorrect amount owed. The balance shown was a negative number, when in fact, there were still about 7 years left on the term of the loan.
At the end of my analysis, there were significantly more liabilities owed, than there were tangible assets. Based on the facts and circumstances surrounding this particular case, there were no expected future earnings, so there was also no intangible value to be had. The net result was to conclude a value that was considerably less than $0.
It is important to keep in mind the fact that sometimes, the subject business doesn’t have any future earnings, and it may very well have a negative value.
By Shawn M. Hyde