In a previous article I discussed the three approaches to valuing a business. These approaches are the Market Approach, the Asset Approach, and the Income Approach. I believe an Income Approach should be used in most instances to value a company. The Income Approach focuses on future cash flow and in my experience future cash flow is the primary determiner of value in most cases. The Income Approach can also be adapted to address unique facts and circumstances. The Market Approach can be challenging to apply if truly comparable public companies or guideline transactional data can’t be located. The Asset Approach does not consider the value of unrecorded intangible assets or the earnings stream (cash flow) of the company and is typically used when valuing a controlling interest. For these reasons I use an Income Approach to value companies more often than the other approaches.
As many are aware, the ongoing impact of COVID-19 and the current economic situation have changed the outlook for many businesses. Businesses are facing supply chain and labor challenges. Supplies and materials have become increasingly difficult to obtain. Prices are skyrocketing and the time to obtain supplies and other materials has increased significantly. Fuel costs have dramatically increased. Many of my clients are having trouble hiring new workers and are seeing increasing labor costs for both new and existing employees. The June 2022 Livingston Survey lowered their forecast for GDP and increased their inflation forecast through 2023. These challenges and the economic outlook negatively impact profitability and cash flow. The outlook for future cash flow has changed from just six months or a year ago.
These circumstances have resulted in unique situations for some companies operating in an industry with a heavy reliance on vehicles and other heavy equipment. During the last two years the price of new/used trucks and heavy equipment increased significantly as supply became scarce. During 2020 and 2021 companies took advantage of the Paycheck Protection Program (PPP) and obtained PPP loans to help keep their workforce employed during the COVID-19 crisis. Many businesses weathered the crisis and applied for and received forgiveness of the PPP loans. Companies operating in industries such as construction, excavating, short and long-haul trucking, well drilling, and similar industries with a heavy reliance on equipment, found themselves with extra cash from the forgiven PPP loans and an increasing cost for trucks and equipment. Many of my clients in this situation invested the extra cash in additional inventory of trucks and other equipment.
Now consider that the current inflationary environment of rising costs and reduced profitability results in lower fair market values determined under an Income Approach. This may be a temporary situation and in the future profitability could increase, but for the near-term profits and fair values are down. Many companies operating in industries with a heavy reliance on equipment and vehicles have inventories of used equipment that are worth much more than they were a year or two ago. In this situation I believe it makes sense to consider the Adjusted Net Asset Method when valuing the companies. A company’s adjusted net asset value is determined by adjusting its assets and liabilities from their book value to their estimated fair market value. An equipment appraiser might be required to determine the fair market value of specialized and used equipment. The difference between the fair market value of its assets and liabilities is the fair market value of the company and could be considered a “floor” value. The company could still be profitable and continued operations may not be in doubt, but its current fair market value determined using the Adjusted Net Asset Method may be higher than using an Income Approach. Depending on company specific facts and circumstances, its current fair market value might best be determined using the Adjusted Net Asset Method.
For more information on McKonly & Asbury’s Business Valuation Services, visit our webpage. Should you have questions about the three approaches to valuing a business, or business valuation in general, don’t hesitate to contact me, T. Eric Blocher CPA, ASA, CVA, at firstname.lastname@example.org.