GOING CONCERN VALUE: Definition and All You Need To Know

GOING CONCERN VALUE: Definition and All You Need To Know
GOING CONCERN VALUE: Definition and All You Need To Know

Without the going concern value assumption, a business is essentially only worth its break-up cost.  The price of a division can be quite low, especially if there are few bidders for the firm’s assets. 

However, with a going concern assumption, a buyer may be willing to pay much more for the business than the book value of its assets might imply.  In paying the going concern value, the buyer will be willing to pay goodwill above the break-up value.  Goodwill is based on a variety of intangible assets, including customer loyalty, intellectual property, customer lists and brand value.

What Is Going Concern Value?

The concept of going concern accounting refers to the assumption that a company will continue to operate for the foreseeable future. 

This allows a company to include the value of intangible assets and expected profitability in its total value.  Unless there is reason to believe that the company is going out of business and going out of business, assume that the company is always going.

Going concern value is the amount a potential acquiree would cost the buyer assuming the business will continue in operation for the foreseeable future.  This is a standard valuation assumption for businesses. 

The going concern assumption is critical because it assumes that the business will continue to have a customer base that will continue to buy from it, employees that will continue to work there, licenses and permits that will remain in effect, etc. 

In short, going concern value is the ability of a business to continue to generate positive cash flows in the future.

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How Does It Work?

While any type of commercial property appraisal is a multifaceted task, appraising the ongoing operations of special purpose properties is particularly challenging. 

Distinguishing a general appraiser from a going concern appraiser is difficult because there is no official certification or affiliation that recognizes their expertise.  However, going concern valuation experience is critical because the valuation process is quite different from a simple comparative cost or sales valuation.

Going concern value is defined as the value created by a verified property transaction;  it includes added value related to the business, which is different from the value of the property. 

Going concern value includes the intangible increase in the value of a going concern that is created by combining land, buildings, labor, equipment and marketing operations.  This assembly creates an economically viable business that is expected to continue.

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Going Concern Value Example

For example, suppose that the liquidation value of Widget Corp.  is 10 million dollars.  This amount represents the current value of inventory, buildings, and other tangible assets that could be sold if the company were completely liquidated. 

However, the current value of Widget Corp may well be $60 million, as the company’s reputation as the world’s leading widget manufacturer and its ownership of patents and related widget production rights means that the company should have a large and stable capital base stream of future cash flows.

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Going Concern Value Real Estate

Valuation of many active properties is not as simple as valuation of the underlying real estate.  If a substantial portion of the value of a business asset is real estate, real estate appraisers increasingly turn to the valuation of the going concern component of the asset.

Much of what passes for real estate isn’t real estate at all.  Real estate is about bricks and sticks, and business is about labor relations and risk management.  Business is business.  Real estate is real estate.

The difficulty in valuing the assets of a going concern arises when the business is closely related to the real estate from which it operates.  More often than not, the real estate, personal property and enterprise value (BEV) components are part of the same package.  They all create value.  Their combination is a “going concern”.

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Going Concern Value Appraisal

Going concern valuation estimates the market value of real estate, operating businesses, and machinery and equipment owned by the same entity, usually with an indefinite useful life. 

A thorough valuation considers the real estate along with the tangible and intangible assets associated with the business. 

The task of the going concern appraiser is to objectively determine whether the business operations support real property and related tangible and intangible assets, i.e. best and best use.

If the business cannot generate sufficient cash flow to cover its real estate assets, then the land may be better served by another use.

Going concern valuation is a unique challenge because the valuer must assess whether cash flow from business operations is sufficient to support total operating expenses. 

A going concern appraiser not only evaluates buildings, land, equipment and intangible assets, he must also determine how the health of the business in question affects the overall value. 

Factors that contribute to maximizing the value of a property include business type, location, area demographics, traffic, existing competition, and more.

Most general appraisers value current businesses using traditional valuation approaches, including cost, sales, and revenue, but may do so improperly, resulting in an inaccurate valuation. 

Going concern valuation requires the appraiser to be experienced in the valuation approaches used by market participants such as brokers and owner-operators.

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How To Calculate Going Concern Value 

When buying an existing business, you will have to agree with the owner, but it is always easiest to agree on a formula. Standard Bank’s guidelines for determining the value of a business include the following formula:

  1. Net worth of a business is the liquidation value of assets minus liabilities
  2. Your current earning capacity is annual earnings with an equal amount of net worth (say 15%)
  3. Include a reasonable annual salary for the owner or manager
  4. Required average earnings (point 2 plus point 3)
  5. Determine the average annual net profit of the business (net profit before paying the owner’s salary) for the last few years
  6. Additional earning opportunity (point 5 minus point 4)
  7. Ask yourself for how many years you are willing to sacrifice additional business profits to pay for kindness (point 6 multiplied by point 3)
  8. Final price (point 1 plus point 7).

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What Is The Difference Between Going Concern Vs. Liquidation Value?

Goodwill is the difference between a company’s liquidation value and its going concern value.  Goodwill consists of intangible assets such as customer loyalty, trademarks and trademarks to name a few. 

All other things being equal, the current value will always be greater than the liquidation value because the cost of acquiring a company is added to the current value of that company.

Going concern value is primarily the ability of the enterprise to generate future profits.  An analyst evaluates a business by looking at the latest trends in the business and the company’s potential for profit. 

A going concern will be evaluated according to operational efficiency, market share, ability to influence the market, technological advantages, etc.  It can be valued using the discounted cash flow (DCF) method, assuming future profitability.

Liquidation value, on the other hand, relates to a situation where a company becomes insolvent and cannot pay its bills. 

An insolvent company may decide to sell its assets one at a time or all at once.  The value received from the sale is usually the market value of the asset less costs to sell.  The liquidation value is very important to the creditors and interested parties to whom the money will be paid.

Conclusion

Going concern is one of the fundamental principles of accounting.  It is assumed that the entity will continue to operate for the foreseeable future.  Conversely, it also means that the entity does not plan or expect to be forced to liquidate its assets. 

According to this accounting principle, the entity allocates income and expenses according to other accounting principles.  If the going concern assumption were not true, then it would be impossible to record prior period expenses or accrued expenses as such.

The concept of continuity is relevant not only from the point of view of the profit and loss statement, but also from the point of view of the balance sheet.  All assets are depreciated accordingly with the same idea that the business will continue to operate.

Going Concern Value FAQs

How Does Cost Valuation Method Work?

The cost method is based on the principle of substitution.  It assumes that investors will not pay more for a property than they would for a substitute property with the same utility.  The cost approach “recreates” the Subject Company by determining the cost of its reproduction.  This can be calculated as reproduction cost—the cost of restoring the company as it is—or replacement cost.  Replacement cost is almost always used because a prudent investor will not copy a property with obsolete features.  The replacement value is then adjusted for depreciation to arrive at the value of the Subject Company.

How Does Income Valuation Method Work?

The income approach assumes that the present total cash value of a property equals the present value of the future cash flows it will provide over its remaining economic life.  This is a reliable approach, but requires detailed analysis.  This valuation method has high model risk because it is based on many assumptions, but often results in a more accurate valuation, especially when combined with other valuation methods.

How Do You Assess A Going-Concern?

When valuing a going concern such as a gas station, an appraiser first considers the value of the land and improvements from scratch, forming a cost approach similar to what a general appraiser would do for any commercial property.  Amortized costs (including any functional and/or external wear and tear) are used to support the classification of real property assets such as land, petrol station, removable M & E (machinery and equipment) and building and site improvements. 

References

  • gasvaluation.com –  CLEARING THE AIR: GOING CONCERN VALUATION VS GENERAL VALUATION
  • experthub.info – How To Calculate The Value Of A Going Concern?

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