How to Determine the Market Value of a Business

by Jessica Kent, Demand Media
Determining the fair market value of a business requires several computations.

Determining the fair market value of a business requires several computations.

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To determine the market value of a business, you need to consider the factors in IRS Revenue Ruling 59-60. This ruling states that the fair market value of a business is the “price at which property would change hands between a willing buyer and a willing seller, each having reasonable knowledge of the relevant facts and neither being under any compulsion to buy or sell.” Factors in the ruling include the business history, industry dynamics, a company’s earning and dividend-paying capacity, whether the company had prior transactions and market data.

Step 1

Prepare an analysis of the business tax returns for a period of five years before the date on which you want to determine fair market value. Alongside the dollar value of each item, create a column that calculates each line item of the income statement as a percentage of total revenue and a column that calculates each line item of the balance sheet as a percentage of total assets. These are called common-sized statements.

Step 2

Analyze the business from a financial perspective using ratio analysis and the common-sized statements. If necessary, make normalization adjustments to the income statement and balance sheet. Normalization adjustments help present the true earning power of the company, and include removing discretionary owner expenses and non-cash expenses, such as depreciation, amortization and bad debt. Discretionary owner expenses include the owner's compensation in excess of industry standards and personal expenses paid for by the company.

Step 3

Employ valuation approaches to determine the fair market value of the business. Valuation experts commonly use more than one valuation approach when the perform their calculations. Use the income approach when the company has an established earnings history. Use the market approach when sufficient market transactions exist for companies in a similar line of business to the company being valued. Use the cost approach when the company being valued has more assets than income, such as a real estate holding company.

Step 4

Calculate the average, or weighted average, of the values you determined with the various approaches. If you are valuing a company that has one owner, and the owner possesses information vital to the success of the company, a keyman discount should be applied. The keyman discount reduces the fair market value for losses suffered in the event the owner leaves the company. When valuing a controlling interest in a company, the addition of a control premium may be warranted. The control premium is added to the fair market value and represents additional value inherent in owning an interest that has more say in making decisions. The value obtained after applying discounts and premiums is the fair market value of the company.

Things Needed

  • Business tax returns
  • General ledger

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