When Should You Use the Book Value Approach to Business Valuation?
I see book value as generally a very secondary approach to valuation. For buying a very tiny business, you can probably just ignore it unless there are significant assets involved. Book value is a good way to test valuations of companies that have significant assets, such as inventory, receivables, equipment, or property.
Book value might also be a good approach if a company has particularly low profits. For example, let’s say a company has only $10,000 in profits and little growth, but it is sitting on $1 million in book value because it has a lot of valuable assets. So, in this case, the selling price of the company might be more based on the book value than the profitability. For example, maybe the selling price would be a 20 percent discount to book value, because the profits are so low.
Related: Fast and Simple Business Valuation
Book Value Is Total Assets Minus Total Liabilities
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 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 EBITDA, cash flow, or net earnings. In a book I published written by Russell Robb, Buying Your Own Business, he identified several situations where the use of book value as the primary method of valuation is prevalent:
- 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. (However, there are other ways to value unprofitable businesses, which I will discuss in a separate presentation.)
- For small distribution companies with sales of under $20 million. Distributors of this size are usually successful because of the departing owner’s 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.
The Book Value Approach to Business Valuation Is Very Commun For Non-Service Businesses
Book value is very common as a method of testing valuations for non-service businesses for these reasons:
- 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 EBITDA 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 five to six multiple.
By pegging the purchase price to a multiple of book value, 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.
The Book Value Approach May Require Some Adjustments
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 whether 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.
Takeaways You Can Use
- Book value should be seen as a secondary approach to valuation.
- Book value is more appropriate when there are expensive assets and low profits.