Valuing an Automobile Dealership
There are three basic approaches that may be used in the valuation of an
automobile dealership:
1. Asset approach
2. Earnings approach
3. Blue Sky approach
Asset Approach.
Asset approach value has the advantage of
being determined easily because the value of assets can be determined by an
independent appraisal or by agreement of the parties.
The asset approach represents a “non-going-concern” approach to valuing a
business, since it assumes that the assets will be liquidated in order to
derive the value. If this is done, the business will cease to operate, and
therefore no longer will be a “going concern”. This approach is applied to
operating businesses when there are no existing or potential earnings, and
thus no value over and above the value of the assets that could be
attributable to the earnings power of the business. When this is the case,
an owner would be better off from an economic standpoint to liquidate the
business rather than continue to operate it.
Earnings Approach.
Anyone wanting to buy a dealership is not
interested in the value of the assets, but in the ability of those assets to
generate earnings. That’s really what a purchaser is buying, not just a
collection of assets. If no earnings have been demonstrated, a purchaser
must forecast what potential earnings might be generated in order to justify
a particular purchase price. To calculate an earnings value, we must do two
things: determine actual or potential earnings value, and arrive at a
proper capitalization rate to apply to those earnings.
- Capitalization Rate. The capitalization rate can be thought of as the expected rate of return that can entice a buyer into making a particular investment. It primarily is a function of the perceived risk of the business or investment that is being considered. If there is a high degree of perceived risk, then there should be a high potential return on investment, and therefore a high capitalization rate.
The proper capitalization rate for any business is a subjective judgment, and it is safe to assume that the buyer and seller are going to have differing opinions about what it should be. Some effort should be made by both parties, however, to equate it with alternative returns available in the marketplace.
- Relationship to Value. The higher the capitalization rate, the higher is the perceived risk of the business and the lower is the price that a potential purchaser is willing to pay.
- Going Concern Concept. Valuing a business to based on its earnings presumes that it will continue as a going concern. This is in direct contrast to the asset approach discussed earlier, which is based upon the value that assets can bring if they are sold – a non-going concern approach.
Blue Sky Approach.
- Concept of Blue Sky. In the automobile dealership business, it is accepted by many to value blue sky (basically the value of the “franchise”) separately and then add that amount to the value of the hard assets that are included in the sale. “Blue sky” is defined as that value of the dealership over and above the value of the hard assets. It is also commonly referred to as “goodwill”.
- Valuing Blue Sky. The formula for valuing blue sky is very simple; it is a multiple of pretax earnings:
Pretax Earnings x Multiple = Value of Blue Sky
The pretax earnings are adjusted for excessive owner’s salary and certain fringe
benefits that might accrue to the owner. The multiple that is chosen is
subjective and depends upon such things as type of franchise(s), location,
population, median income, competition, market share, condition of
facilities, status of the economy, number of units allocated, etc.
The formula for valuing a dealership using the blue sky approach is as follows:
Value of Dealership = Blue Sky + Tangible Asset Value
In effect, this method combines the earnings approach and the asset approach to
arrive at a value. It should be noted that this is a fairly unconventional
approach to valuing a business.
Stock Versus Asset Sale.
Since the 1986 Tax Reform Act was enacted,
the issue of whether a business changes hands on the basis of stock or
assets is more important than ever before. In the past it was possible,
under various sections of the tax code, to sell assets and subsequently
liquidate a business without having to pay tax at two levels – corporate and
personal. This is no longer true. The result of this change is that when a
business sells assets, it will pay a tax on the depreciation recapture and
capital gain, and when the corporation is finally liquidated and the
proceeds are distributed to the owner, the shareholder will pay another tax
on the capital gain.
The fair market value of some of these assets is fairly
subjective, and it pays to be aggressive in determining their value in order
to take advantage of the tax deductibility of depreciation.
The seller should consider allocating the sales price to the
following to minimize income tax from the sale:
- Allocate to Depreciable Assets.
- Non-Compete Agreement. Some of the compensation to the seller can be in the form of a non-compete agreement in order to preserve the deductibility of the payment and to remove the sales proceeds from the corporation to eliminate one level of tax. The amount allocated to the non-compete must be reasonable in light of all the facts and circumstances.
- Consulting Contract. It is also possible to pay the seller on a consulting contract. On the other hand, these payments are not secured in any way, and thus pose a risk of default. In addition, the IRS could challenge the reasonableness of the amounts and reduce them in order to increase the amount allocated to goodwill and therefore increase taxes.
In the final analysis, it is difficult to establish any concrete guidelines on these various factors. Each deal is subject to attack on its merits, and the key is to be reasonable and to have proper documentation for your position.