Book Value
Book value, a multiple of book value, or a premium to book value is also a method used to value manufacturing or distribution companies. Book value, of course, is total assets minus total liabilities and is commonly known as net worth.
The book valuation technique is usually used as a method of cross-testing the more common technique of applying multiples to EBIT, cash flow, or net earnings. In the following situations, however, the use of book value as the primary method of valuation is prevalent:
1. When the company is losing money on an operating basis. In such cases, there are no earnings on which to apply the multiples previously discussed. Therefore, the reconstructed or fair market value of total assets less total liabilities is used for the valuation.
2. For small distribution companies with sales of under $20 million. Distributors of this size are usually successful because of the departing owners’ many close relationships with the company’s suppliers and customers. These relationships are tenuous because they are usually noncontractual and nontransferable. Such companies usually sell at their book value plus a modest premium.
Book value is very common as a method of testing valuations for nonservice businesses for these reasons:
- 1. If the primary method of valuation is using a multiple of earnings, it is helpful to take the industry average of the book value multiples of other companies recently sold. Book value serves as a reference point. Some buyers will raise or lower their EBIT multiple for valuation purposes based on the relationship to the proposed selling price; some buyers will use only multiples of 4.5 to 5 times EBIT. If book value is higher than half the selling price, some buyers will use a 5 to 6 multiple.
2. By pegging the purchase price to a multiple of book value as of the date a purchase and sale agreement has been signed, the buyer is protected against a decline in the value of the business between the signing of the purchase and sale agreement and the completion date of due diligence.
When the book value technique is used, there is an important variation that a seller will probably want the buyer to consider. The assets may have a far greater value if the values are recast to reflect fair market value for machinery, equipment, buildings, and land. Also, the inventory might be adjusted to reflect current values and to pick up items that have been written off in order to minimize taxes. The buyer must also determine that all the assets are actually earning money for the business. If they are not, he or she should request an adjustment in the purchase price to reflect this condition.
* Source Adams - Buying Your Own Business
Identifying opportunities, Analyzing true value, Negotiating the best terms... by Russell Robb