What Part does Equipment Play in Values?
I’ve mentioned business values based on earnings and ones based on parts as being the two basic approaches to valuing a business. Under the earnings approach, I have written about capitalization of earnings which is one of a number of earnings approaches. An astute reader wrote wanting to know more about what role equipment plays in this value.
Let’s review. Capitalization of earnings is similar to valuing earnings from a bank account. If we’re earning $100,000 a year and banks are paying 10% interest (I wish), then the bank account value is imputed as $1,000,000 ($100,000 / 0.10).
Now our reader says, “Yeah, butta, I’m not sure that capitalization of earnings without taking into account equipment is the best way to arrive at value. It would seem to me that a combination of both is important. … So … to pick a random figure of 25% or 50% falls to adequately address the real value of a business ….”
This is why I like these messages. I quickly see where I’m confusing you. Thank you for the question.
Capitalization of earnings gives a hard number, in this case, a hard number of $1,000,000. Then I mentioned that an active investment (running a business) was always discounted when compared to passive investments (bank accounts) and I said I usually saw it in the 25% to 50% range based on “the probability of maintaining earnings.”
Which would you rather have: 1) Earnings of $100k coming to you while you sit on the beach (passive income) or 2) earnings of $100k from your toil in a business (active income)? Boy I sure hope you said number one.
To clarify, a business under these circumstances of earning $100k where 10% interest income is common would be worth somewhere in the $250,000 to $500,000 range.
Now, let me add to that. The 25% to 50% range I cited isn’t random.
If the business has outdated and/or worn equipment then that would decrease the business’ value on the range because the probability of maintaining earnings without additional investment would be less.
Likewise, a business in a market that is shrinking would be discounted more than a business in a really fast growing market.
A business with a hot and growing product line would be valued on the range more than one with an old and tired one.
And a business with all long-term employees who were expected to retire within three years would also be worth less.
So, the range is what results from these various factors and the specific value is where equipment, market and other conditions come into play using a capitalization of earnings method.
Now, this isn’t the only earnings method. There are more which we’ll cover. But each earnings method results in a range and that the precise value of a specific business then is adjusted for these factors and more regardless of the earnings method used.
And to complete our review of the last message remember this. Parts are parts: presses, equipment, customer list and whatever. Add up the parts and that’s the value. Sorta like selling an antique car for scrap metal. Not the best way to get value out of the business but it’s commonly the only way to value low-earnings based companies.
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We do provide on-site valuations of businesses that include an estimate of value as well as include recommendations of “fixes” that will improve earnings and thus value. This is particularly valuable for owners with three, five or even ten year time horizons. If you are ready to sell right now, we can provide an arms’ length estimate of value for your planning purposes. Email me at firstname.lastname@example.org and let’s see where you are.
Do you want to transition to son/daughter or employee?
I was pleased to work with a business in Chicagoland this past week whose owners are preparing to do this. Parents are in their early 60s and are a little light on their retirement funds. Son wants to take over so their consideration has to be what they can expect as income from the transition as well as how well trained is the son to run the business so that income can be guaranteed?
Yes we do that.
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In the meantime, here’s hoping that all your trails will be happy ones.