Most business valuations are substantially driven by the company’s historical financial statements, moderated by other factors such as: location, brand, management and so on. In truth and in fact, the dealership’s balance sheet represents less than half of the information needed to correctly value a car dealership. The balance sheet is nothing more than a starting point from which a number of factors must be added and subtracted to determine the true value of the assets.
Valuation of new car dealerships has to do with projecting future profits and opportunities based on the “dynamics” of the particular dealership being valued and the car business itself.
The Internal Revenue Service recognizes that appraisals include more than financial statements: “The appraiser must exercise judgment as to the degree of risk associated with the business of the corporation that issued the shares, but that judgment must be related to all other factors affecting the value”. Revenue Rule 59-60, Section 3.03.
DEFINITION OF MARKET VALUE
The definition of market value according to the American Institute of Real Estate Appraisers Dictionary of Real Estate Appraisal is: “The most probable price in cash, cash equivalent terms, or other accurately disclosed terms, for which the appraised property will be shall sell in a competitive market under all the conditions required for a fair sale, with the buyer and the seller each acting prudently, knowingly and in their own interest, and assuming that neither is under duress”. American Institute of Real Estate Appraisers, Dictionary of Real Estate Appraisals. (Chicago: American Institute of Real Estate Appraisers, 1984), 194 195.
In Income Judgment 59-60the Internal Revenue Service defines “fair market value” as follows: “…the price at which the business would change hands between a willing buyer and a willing seller when the former is not required to purchase and the latter is not under any obligation to sell, both parties having reasonable knowledge and relevant facts.
The purpose of Revenue Resolution 59-60 is to outline and generally review the approach, methods, and factors that should be considered when valuing the capital stock of closely held corporations.
The methods discussed in the Income Resolution apply to the valuation of corporate stocks where market quotations are unavailable or so scarce that they do not reflect fair market value.
The ruling goes on to state that no fixed formula can be devised for determining the fair market value of gated estate shares and that the value will depend on such considerations as:
(a) The nature of the business and the history of the company since its inception.
(b) The economic outlook in general and the condition and outlook of the specific industry in particular.
(c) The book value of the shares and the financial condition of the business.
(d) The earning capacity of the business.
(e) The ability to pay dividends. The ability to pay dividends is often more important than a company’s history of distributing cash to shareholders, especially when valuing controlling stakes.
(f) Whether or not the business has goodwill or other intangible value.
(g) The sales of the shares and the size of the block of shares to be valued.
(h) The market price of the shares of corporations engaged in the same or a similar line of business whose shares are actively traded in a free and open market, either on a stock exchange or over the counter. With respect to the sale of an individual dealer, the best comparable is the amount the public company paid or received to buy or sell a similar dealer, not the value of the public company’s stock or earnings multiple, per se, which is reflected in the stock market.
In practice, several different formulas have been used to arrive at the fair market value of a new car dealer:
1. Return on Investment (or Earnings Valuation) Formula: The value of a business to a particular buyer based on a return on investment analysis. This value varies from buyer to buyer, depending on the buyer’s investment criteria, and may or may not reflect fair market value. The National Automobile Dealers Association (NADA) refers to this value as “Investment Value.” A Dealer’s Guide to Valuing a Car DealershipNOTHING June 1995, Revised July 2000.
The capitalization rate is determined by the stability of the dealer’s earnings and the risk involved in the automobile business at the time of sale, investment, or valuation. This method is highly subjective as the capitalization rate is based on the individual appraiser’s perception of business risk; Consequently, the less risk the appraiser perceives, the lower the capitalization rate and the higher the price he expects a potential buyer to pay for the business.
In short, the capitalization rate is the appraiser’s opinion of the rate of return on investment that would motivate a prospective buyer to purchase the dealership. Considerations include those specified in Income Resolution 59-60, as well as the available rate of return on alternative investments.
2. Adjusted Net Worth Formula: Net worth of the company, adjusted to reflect the appraisal value of the assets used in the daily operations of a business, assuming that the user or purchaser will continue to make use of the assets. To this value of “net worth” will be added the blue sky or the goodwill, if any. The “adjusted net worth formula” is the most common method used to buy and sell a new car dealership.
3. Orderly Liquidation Formula. This method values the assets as if they all had to be sold, not in a “fire sale,” but in an orderly manner and without time constraints. Typically, if the dealership is profitable, some value will still be attached to goodwill.
4. Forced liquidation. The lowest of all values, forced liquidation means that all assets must be sold in a forced sale, such as at auction, a creditors’ sale, or by order of a bankruptcy court. A bankruptcy proceeding involving a new car dealer almost never generates goodwill. This might be the most appropriate formula if the dealership has no lease (or only a short term left on its lease) and cannot, in practice, relocate.
5. Income Formula. The revenue formula basically takes the store’s profit and multiplies it by an appropriate capitalization rate. The trick here is the definition of “earnings”. To determine “earnings,” a prospective purchase could use any combination of the following:
(a) current earnings
(b) average earnings: add the last five years and divide by 5
(c) weighted average earnings – usually a reverse weighting with current year times five, last year times four, year before last times three, four years ago times two, five years ago times one, then adding and dividing for 15
(d) cash flow: net income plus agreed add-ons such as depreciation, LIFO, personal expenses, excess bonuses, and others
(e) expected earnings – projected future earnings discounted to present value.
6. Fair value. NOTHING also refers to a third value in addition to “Market Value”, “Investment Value”, which it calls “Fair Value”. NADA describes “Fair Value” as “…used primarily when a minority shareholder objects to a proposed sale of the company when assessing liquidated damages.” and defines it as: “The value of the minority interest immediately prior to the transaction to which the dissident objects, excluding any appreciation or depreciation anticipated to the transaction and without reference to a minority or non-marketing discount.”
The NADA guide states: It is not common for car dealers to come across this particular valuation standard. this author has never used, nor have you ever seen this value used in regards to car dealership valuation.
As can be seen in this report, this author in discussing valuations excludes what NOTHING describes as “Fair Value”.
7. The Biggest Dummy Theory. The publication of the National Association of Automobile Dealers (A Dealer Guide to Valuing an Automobile Dealership, NADA, June 1995), puzzles, in part: “A rule of thumb is more correctly known as a ‘theory of the greatest fool.’ However However, it is not a “theory of valuation” (In its “Valuation of a Car Dealership: 2004 Update”, NADA removed the reference to “fool” and simply states that the theory “…is rarely based on on sound economic or valuation theory,” but advises sellers to “do it, and maybe someone will be stupid enough to pay [it].”
The considerations for valuing new car dealerships are more complex than those used to value most other businesses. Dynamics like the unique requirements of car manufacturers and dealers can limit the amount of money that can be paid by a dealer, regardless of the perspective that clients may offer to pay the store.
Thus, the value of a new car dealer varies depending on the needs and ability of the buyer, and consequently the same dealer could have two different values for two different buyers and both values would be correct.
Therefore, our valuation of the subject dealer must be considered in the context and limitations of the facts and history of new car dealer sales as described herein.