Bad Appraisal Methods
There are many bad appraisal methods in wide use that fail to yield fair and rational prices for the equity of firms with goodwill. Only by accident will any of these methods even get close to a fair and rational price. Trained and credentialed appraiser utilize one of three flawed methods:
1. Income (Click here for a full description)
2. Asset (Click here for a full description)
3. Market (Click here for a full description)
The quick proof of the inadequacy of these methods lies in the fact that virtually no credentialed appraiser who also owns their own accounting practice would ever consider using any of these methods in setting a value for their practice goodwill. They would instead rely on the most widely used methods endorsed by business brokers, rules of thumb or formulas (click here for a description of this method).
Another proof of the bankruptcy of current methodology is the fact that at the end of any appraisal project, appraisers are admonished to provided a “sanity check”, which involves trying to imagine if any actual rational buyer would pay the equity value derived using the accepted methods. The implication (and it is too often correct) is that using accepted methods can yield values that are well, insane. If these methods are acknowledged to possibly yield insane value, why not just start with a sanity check? Sanity, in the form of specifying plausible values that might be paid by actual real world buyers is precisely what my Fair Commission Model (FCM) model is about.
Up until the development of the FCM to which this website is devoted there simply has been no alternative that makes any economic sense in a non-arbitrary fashion. Click here for a free downloadable pdf that describes the FCM model. That said if you are buying or selling a business with goodwill you can ill afford to ignore rules of thumb because these currently reflect how businesses are currently priced. As such this method represents the least bad method now available.
Equity vs. Asset Sales: The Fair Commission Model (FCM) is a Hybrid
In the application of the FCM, the value assigned to goodwill usually establishes the upper bound price that an optimal buyer will pay for the equity of the subject company (SC). Most main street firm sales are consummated as asset sales. This means that the buyer acquires certain assets of the firm but does not acquire the equity of the firm directly.
In valuing an SC, the appraiser is required to assign a value to the equity of the firm. But in many, if not most cases, the buyer will only acquire the goodwill and certain fixed assets of the firm. The buyer will not usually be acquiring the cash or receivables if they exist nor will they be assuming any liabilities of the SC. Therefore, the appraiser in order to arrive at a value for the total equity of the firm in most circumstances will have to assign a value to what a buyer would pay for the goodwill and any fixed assets and then add or subtract the net value of the assets and liabilities that the buyer will not acquire or assume. Looked at in this way the FCM can be considered an asset method. The price that the buyer will pay for the goodwill and fixed assets is added to the net assets that the buyer will not acquire. However, the value of goodwill is determined using an income method, albeit not a variant of the income methods now in use. Goodwill will be valued based upon the future net economic benefits that will be realized by an optimal buyer. In that respect it follows income methods now widely used.
However, the FCM only considers future economic benefits over a limited time period, identifies and embeds specific risks in the forecast through the use of computer simulation and does not recognize the legitimacy of discounts for lack of marketability. Click here for a discussion of these discounts.