February 1, 2006
Many of our clients complete a balance sheet at the end of the year so they can track the earned gain in net worth from year to year.
By earned gain in net worth we mean the increase due to cash earnings rather than appreciation in real estate values. Another good reason to do this is if you then divide that earned net worth increase by beginning of the year net worth it gives you return on equity (ROE), a useful benchmarking tool. The average of our clients' ROE is 16.1% as opposed to the industry average of about 4%.
Valuing your farm business by net worth is common, but not always the best practice. Another way to estimate value is determining the present value of future cash flows. Cash is king and a company has great value if it consistently generates lots of cash.
Many factors contribute to the earnings a farm business can generate. Another consideration in estimating the amount of cash a company can generate is evaluating the intellectual capital, technology, competitive market advantages, management and employees.
These factors are relied upon heavily and add value to every business, whether it's a business on your hometown Main Street, your farming operation or Russell Consulting Group.
Valuing a business based on cash generated is a concept used by most large companies and can be useful in your business when making decisions on buying or selling farms, equipment or businesses.
So there are really two ways your farm business can be valued — the market value, which is market price less taxes, and an intrinsic value based on the value of past and anticipated future cash flows.
A guideline I use to determine the intrinsic value of a privately owned business is five to seven times past earnings. I use the bottom or top of the range based on other factors including the consistency of earnings, volatility of the industry, regulations and overall industry competitiveness.
Granted, the price-to-earnings ratio of S&P 500 is 18.5:1 as of Nov. 30, 2005, so why take earnings times five or seven? First of all, the stock market may be over valued. The price-to-earnings ratio of the S&P 500 in 1985 was 10.1:1. Plus stocks are liquid and most privately owned businesses are not.
Remember, market value and intrinsic value may not be the same, but over the long run they must and will come together. It happened to farmland values in the mid-1980s.
If you take your change in net worth in the last three or five years and multiply it by seven, for example, you can get a ballpark idea of the value of your business based on earnings potential assuming the future will be somewhat like the past.
Then compare that to the net worth on your balance sheet. It may provide an interesting starting place for your management team discussions, strategic planning, goal setting and a variety of issues.
Using the guidelines I outlined in the main article, let's look at three different risk management plans.
The first is an 800-acre corn and soybean operation. All 800 acres are rented. This young couple also has a hog building where they contract feed hogs for another producer. His last three years average earned gain in net worth times seven equals $630,000 and the balance sheet net worth is $712,000. Pretty close, so you could say the intrinsic value and market value are similar.
The second is a young farmer with a hog operation. I looked at the last five years averaged earned gain rather than three to get through a normal four-year hog cycle. It averaged $120,000. Seven times that is $840,000. The balance sheet reflects a $950,000 net worth. Pretty close.
The third is a cash grain farm with a large land base. The three-year average net worth increase is $150,000. Seven times that would be $1,050,000. The balance sheet net worth is $3,300,000. The intrinsic value of the business is far less than the market value. I see this quite often where there is significant land base. It means the market value of land is greater than the intrinsic value or earnings capacity. This is partly explained by the fact that farmland has appreciated about 4%/year over the long run and people buy land anticipating that increase in value.
Moe Russell is president of Russell Consulting Group, Panora, IA. Russell provides risk management advice to clients in 24 states. For more risk management tips, check his Web site (www.russellconsultinggroup.net) or call toll-free 877-333-6135.
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