value

Article Dean Dorton

Stock market analysts and commentators have credited the Tax Cuts and Jobs Act with boosting market prices during late 2017 and early 2018. As we have discussed in previous articles, the tax code reform has many nuances with unique consequences for each business. We would like to isolate one significant change in the tax code and discuss its impact on business value — the Federal corporate income tax rate cut from 35% to 21%.

As detailed in a previous valuation article, three methods are commonly used to value a business. We focus here on the income approach, which reflects the fact that the value of a business is equal to the sum of its future cash flows discounted to present value. Clearly, a lower corporate income tax rate directly increases the future cash flows of a business, as shown in the example below.

Corporate Tax Rate 35% 21% % Increase
Pre-tax income $1,000,000 $1,000,000
Taxes (350,000) (210,000)
Free cash flow $650,000 $790,000 21.5%

Regardless of the amount of pre-tax income selected, the 21.5% increase to free cash flows stays constant. As such, the Federal corporate tax rate decrease from 35% to 21% increases the free cash flows of a corporation by 21.5%, assuming all other factors are held constant.

The next step of the income approach is to discount the free cash flows to present value. Assuming the discount rate (i.e. rate of return) an investor would accept/demand for an investment in the business remains the same, the 21.5% increase in cash flows results in a 21.5% increase in company value. Accordingly, we conclude that, all other things being equal, the decline in the corporate tax rate from 35% to 21% increases value by 21.5%.

Though this article focuses on the direct impact on value of the corporate tax rate change in isolation, it should be noted that the decline in the rate could have indirect impacts on value, as well. For example, after-tax borrowing costs will increase as a result of the federal tax rate decline, which may impact the weighted average cost of all capital, which in turn impacts a company’s value. In addition, other provisions of the new tax law may also impact value. For example, the more favorable depreciation rules associated with the new law could lower the effective tax rate of a company, resulting in increased cash flows, and thus increased value. In general, and all other factors being equal, we believe that the value of most companies will increase as a result of the new tax law, but just how much is a function of several (perhaps many) factors, several of which are difficult to evaluate.

For more information or questions about business valuation, please contact David Angelucci at 859.425.7695 or dangelucci@deandorton.com or Shelby Clements at 502.566.1052 or sclements@deandorton.com.

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Article Dean Dorton

In our last newsletter, Determining and Increasing Business Value, we discussed the three primary approaches to valuing a business. We described how value hinges on projected cash flows and risks associated with achieving them. And, we explained that a business owner can increase value by increasing cash flows and lowering risks. In this article we focus on the various levels of value associated with a business (or business interest), and we discuss strategies for maximizing value.

Though we often think that value means one specific amount, various levels of value are associated with business interests. These levels of value reflect varying degrees of control, marketability, and synergies with other enterprises. The levels of value, from highest to lowest, are illustrated in the following example:

$12 per share Synergistic (or Strategic) Value (reflects a 20% strategic premium)
$10 per share Control Value (reflects control and liquidity)
$7 per share Noncontrol, Marketable Value (reflects a 30% discount for lack of control)
$5 per share Noncontrol, Nonmarketable Value (reflects combined discounts for both lack of control and liquidity of 50%)

In arms-length business acquisitions lacking strategic or synergistic features, buyers and sellers tend to negotiate a purchase price that approximates the control value of the business. A buyer seeks to maximize value by identifying a target with strategic or synergistic potential. If the buyer is able to purchase the business at control value, but operate it at a level consistent with strategic value, the buyer has effectively purchased the business at a “bargain.” By capitalizing on synergies or other strategic advantages, the buyer’s return on investment will be enhanced. A buyer tries to negotiate a purchase price without paying for synergies or other strategic value that the buyer brings to the deal, while recognizing that if multiple potential buyers who recognize synergistic or strategic potential are involved, the purchase price may get “bid-up” to an amount approaching strategic value.

One of the ways to realize strategic value is by buying a competing company. By eliminating a competitor, the buyer is able to capture a greater share of the market, providing opportunities for increasing revenues and reducing costs. Similarly, a buyer can purchase a supplier or distributor to create vertical integration. This will enable the buyer to save the “mark-up” in supply or distribution costs, resulting in greater profits. Other strategic acquisition value can result from purchasing one or more companies, enabling the buyer to generate economies of scale, leverage existing expertise and know-how, provide for “one-stop” shopping, or create a level of “critical mass” that provides an advantage in the marketplace.

We have approached the idea of maximizing value from a buyer’s perspective, but a seller can also maximize price by marketing and selling to a strategic buyer that can create synergies between its existing business and the targeted business. The seller, though, often needs multiple potential buyers in order to realize a price that reflects strategic value.

If you have any questions or would like to discuss your business, please contact one of the members of our forensic accounting and business valuation group.

David Parks, dparks@deandorton.com

John Herring, jherring@deandorton.com

David Angelucci, dangelucci@deandorton.com

Missy DeArk, mdeark@deandorton.com

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Article Dean Dorton

Business owners naturally are interested in the value of their businesses. In this article, we provide a brief description of the primary approaches to valuing a closely-held business (asset, market, and income approaches), elaborate on the income approach, and offer some brief thoughts on how to increase the value of one’s business.

Under the asset approach, a valuation analyst looks to the underlying assets and liabilities of the business (whether recorded on the company’s balance sheet or not) and aggregates them to arrive at a value of the business. An asset approach is instructive for businesses whose primary value is derived from its financial assets and tangible assets (e.g. inventory, equipment, real estate), but it often fails to adequately capture the value of an entity’s intangible assets (e.g. customer relationships, trade names, patents, assembled workforce, and goodwill, for example) because they often are difficult to separately value.

The market approach relies heavily on comparison and substitution to derive value estimates. Much like a residential real estate appraiser does in valuing houses, a business appraiser attempts to find other businesses (for which there are known trading prices) that are comparable to the business being appraised and then uses those prices to estimate the value of the subject company. Because the values used in this approach are rooted in real-world transactions, this approach often results in the best estimate of fair market value. However, it often is difficult to identify reliable comparable companies or transactions due to the unique features of the subject company and frequent lack of available information about the comparable companies.

Due to limitations of the asset and market approaches, the income approach often is the best approach for valuing closely-held businesses. The income approach reflects that the value of a business is equal to the sum of its future cash flows discounted to present value. It recognizes that a buyer is willing to pay a price today in exchange for future cash flows and a seller is willing to forego future cash flows in exchange for a current price. Employing the income approach requires a forecasted stream of future cash flows and a discount rate with which to convert the future cash flows to present value. The discount rate represents a rate of return investors would require considering risks associated with achieving forecasted cash flows.

To derive an appropriate discount rate, the analyst considers rates of return historically required by investors owning similar businesses, taking into account the unique strengths, weaknesses, opportunities, threats, and risks associated with the subject company relative to those of the similar businesses.

Note that higher cash flows and lower risks yield higher values. Thus, a business owner can increase the value of his business by taking steps to increase cash flows and to reduce risks. Ways to increase cash flows include growing revenues, reducing expenses, optimizing working capital levels, and optimizing the capital structure of the business. Risks can be reduced through customer, supplier, and product diversification, cross-training of employees, management succession planning, geographical expansion, and a host of other initiatives. Each of these strategies requires proactive planning, purposeful implementation, and time to realize the benefits.

If you are considering a sale of your business in the next few years or in increasing its value, please contact one of the members of our forensic accounting and business valuation group.

David Parks, dparks@deandorton.com

John Herring, jherring@deandorton.com

David Angelucci, dangelucci@deandorton.com

View David Parks’ Bio