The question every manufacturer wants answered: What’s the value of my business?

The value of your manufacturing company depends on a variety of factors, such as what products it manufactures, how it’s expected to perform, where it’s located and why you’re appraising it. Let’s take a closer look at the current merger and acquisition (M&A) market and how appraisers use three techniques to value manufacturers.

Hot market

Reuters reports that worldwide M&A deal volume in the third quarter of 2015 was the third highest quarter on record despite concerns over the Chinese economy, declining energy and commodity prices, and volatility in the financial markets.

Hot manufacturing segments include technology, health care and life sciences, and consumer markets. Sellers in these segments may wind up in a bidding war that drives up their values. But beware that some buyers are still trolling for bargains, so don’t take the first offer you receive without obtaining a formal appraisal first.

Three valuation methods

Appraisers use these three valuation approaches to value manufacturers.

1. Cost approach — Manufacturers rely heavily on tangible assets, so the balance sheet is a logical starting point. Some items are worth more (or less) than book value.

For example, manufacturers sometimes use the same depreciation methods for book and tax purposes. Accelerated depreciation methods, including expanded Section 179 and bonus depreciation deductions available in recent years, have significantly lowered the net book values of fixed assets — including machines, large tools, heavy-duty vehicles, computers, software and office furniture — below current market values.

Receivables also may need to be adjusted for bad debts. Inventory may include obsolete or unsalable items. And contingent liabilities — such as pending lawsuits, environmental obligations and warranties — also must be accounted for.

But the biggest adjustment is for intangible assets, such as internally developed patents, brands and goodwill. The cost approach generally omits intangible value, but it can serve as a useful “floor” for a company’s value. Appraisers typically use another technique to arrive at an appraisal that’s inclusive of these intangibles.

2. Market approach — Sales of comparable public stocks or private companies may be used to value your business. Finding comparables can be tricky, however. Many small manufacturers tend to be “pure players,” whereas public companies tend to be conglomerates, making meaningful public stock comparisons difficult.

When researching transaction databases, it’s essential to filter deals using relevant criteria, such as industrial classification codes, size and location. Adjustments may be required to account for differences in financial performance and to arrive at a cash-equivalent value, if comparable transactions include noncash terms and future payouts, such as earnouts or installment payments.

3. Income approach — Expected future cash flows can be converted to present value to determine how much investors will pay for a business interest. Reported earnings may need to be adjusted for a variety of items, such as accelerated depreciation rates, market-rate rents, and discretionary spending, such as below-market owners’ compensation or nonessential travel expenses.

A key ingredient under the income approach is the discount rate used to convert future cash flows to their net present value. Discount rates vary depending on an investment’s perceived risk in the marketplace.

Critical adjustments

When using the market or income approach to arrive at a preliminary value, the appraiser may need to adjust for excess working capital if you carry more cash or inventory than the average manufacturer. Nonoperating assets are also added back to an appraiser’s preliminary value.

Additional adjustments may be required if a business owns its facilities because real estate ventures differ from manufacturers in terms of risk and return. A real estate appraiser may be called in to value your facilities.

Appraisal pros do it best

These considerations are just a sampling of the subtle nuances that go into valuing a manufacturer. Each business is unique. Owners who rely on gut instinct or do-it-yourself valuations may leave money on the table when they sell — or risk overpaying when they expand through acquisition. Consider hiring a professional appraiser to value your company before taking any action.

The limits of industry “rules of thumb”

Simplified formulas can give owners a “quick-and-dirty” estimate of what their businesses are worth, but these rules of thumb are often ambiguous and unsupported by specific empirical evidence. They should never be used as the sole method of valuation.

One well-known rule of thumb for manufacturers is five times earnings before interest, taxes, depreciation and amortization (EBITDA). This formula is supported by recent market data. In 2014, the median EBITDA multiple for the overall manufacturing sector was 5.3 times, compared 3.6 times for all major business sectors, according to Pratt’s Stats transaction database. Before hanging your hat on this simplified formula, it’s important to recognize that manufacturing companies vary significantly — warranting EBITDA multiples above or below this generic median.

Formulas may serve as a helpful sanity check, however. If a manufacturer that reports $500,000 of EBITDA expects to sell for $5 million, the industry formula implies that the owner’s expectation seems unreasonable. But further investigation is necessary to definitively value the business.

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