Determining foundry market value means everything has a price.

Part one of this series explored the wisdom of knowing what your foundry is worth, This second part describes various steps in making a careful estimate of a foundry's fair market value (FMV), including consideration of its various tangible and intangible assets. Determined values are also useful in allocating the purchase price to individual assets for financial and tax reporting purposes.

Fair market value is defined as the price at which property would change hands between a willing buyer and a willing seller, neither of whom is under any compulsion to buy or to sell and both having reasonable knowledge of all relevant facts.

Principal sources of information in performing a valuation include: * five years of prior financial statements prepared by the foundry's accountants; * managements' plans, budgets and forecasts, including the foundry's capital budget for the next three to five years; * general economic and specific industry data; a company records and operating statistics. Procedures used to value a foundry include: * analysis of historical operating results; * analysis of general economic conditions and the foundry industry outlook; * interviews with management on financial policies and operating procedures; * a physical inspection and analysis of the foundry's personal property (furnaces, conveyors, furniture and fixtures, vehicles, office equipment, etc.) and equipment maintenance policies. Valuation Theory

Three traditional valuation approaches are typically employed: market, cost and income.

The market approach is a valuation technique by which fair market value is estimated based on comparable actual stock transactions in the private or public markets. This technique can also be applied to value individual assets by comparing the subject asset to other similar asset sales.

The cost approach is a methodology that uses replacement cost as an indicator of FMV, assuming that a prudent investor would pay no more for a physical asset than the dollar amount for which he could replace the asset with a new one of like utility. To the extent that a current asset will provide less utility than a new one, the ultimate value is thus less. Replacement cost also infers that indirect costs (engineering, transportation, installation, etc.) incurred with any startup are factored in.

The replacement cost is then adjusted for loss in value due to a variety of circumstances like: * physical deterioration (wear and tear on plant and equipment); * functional obsolescence (advances in the state of the art, new materials, improved processes); * economic obsolescence (government regulation, industry overcapacity, market changes in demand).

The income approach is a technique by which FMV is estimated on the basis of the available cash flow a foundry can be expected to generate in the future. It recognizes the business as an investment that should yield a rate of return. It examines the following: * the annual projected after-tax cash flows the foundry will generate; * the cash flows discounted at an appropriate rate of return, taking into account the relative risk of not realizing the projected cash flow and the time value of encumbered funds; * the estimated residual value of the asset at the end of its remaining useful life; * the residual value converted to its present value equivalent; * the present value of the after-tax cash flow combined with the present value of the determined residual.

The rate of return in the income approach is the combined rate of return required by long-term debt and equity investors. It is reflective of other market investment yields in relation to the relative risk associated with the foundry. A Case History

XYZ is primarily a jobbing foundry producing aluminum products for aerospace and automotive companies. It uses sand and permanent mold systems and is also in a joint venture to produce high-tolerance expendable pattern castings. XYZ is being valued by a potential buyer.

The firm's value is affected by national, industrial and firm specific economic factors. An analysis of these areas provides a current outlook of the foundry industry and XYZ's own competitive position and growth potential.

The process starts with a review of the national economic environment as described by several sources (The United States Executive Report, Value Line Investment survey, Federal Reserve forecasts, government economic indicators, etc.).

Also included is the foundry industry outlook as covered in the U.S. Industrial Outlook for the nonferrous metals and automotive vehicle industries. Further, XYZ's own historical data is carefully reviewed, including its growth rates, cost structures and profit margin trends.

The potential buyer first develops a value for XYZ based on its potential earnings and "free" cash flow as projected over a planning horizon typically between 5-10 years. Free cash flow is defined as cash flow after taxes, required capital investment and working capital for forecasted sales growth have been met. Interest expense is excluded because the cost of debt will be factored into the discount rate developed.

The steps described in the income approach are followed to determine a business enterprise value using the discounted cash flow method. This results in an investment value to the buyer based on a target weighted average cost of capital used as the discount rate. This approach concludes that the assembled assets of the foundry are only worth what free cash flows they can generate as a going concern. It is expressed in current dollars and assumes a market rate of return.

The market approach was next reviewed; however, no public market comparables were found for XYZ. If there had been, various "market multiples" would be computed and applied to XYZ data as another method of valuation (price/earnings, price/ book value, price/assets, etc.).

Finally, the buyer was interested in establishing the value of XYZ's investment in its assets as represented in part by its balance sheet. The cost approach was used to establish current replacement costs in use for all fixed assets. The sum of all tangible and intangible assets (expressed as FMV) minus liabilities gives an estimate of equity value. Two important intangible assets were also identified and valued in the process. The steps are as follows: Fixed Assets

The real estate owned by XYZ was valued using sales of comparable industrial properties in the local market and expressed on a square foot basis. Adjustments were made for age, condition, type of construction, floor plan and location. Replacement value was computed using current construction costs and material costs (the cost approach).

Next, machinery and equipment were appraised based on a physical inspection of the facility and referenced to XYZ's fixed asset ledger. Original cost data was referenced to current prices and then adjusted downward to reflect age, condition and various obsolescence factors. Estimates for generally available pieces of equipment were also checked in the used equipment market. Since the equipment is in use, various indirect costs such as installation and testing were added to the computed replacement value.

The buyer also wanted to recognize certain intangible assets that add to value, but are not reflected on XYZ balance sheet. One such asset is the value of XYZ's skilled workers-in-place. Assembled Work Force

The assembled work force for XYZ can be valued using the cost approach. The expenditures required to recruit, interview, select and train a work force comparable in size and efficiency to the current work force is determined at the valuation date. The cost approach measures the one-time cost the purchaser would incur to replace XYZ's personnel.

Additionally, XYZ has a substantial backlog of orders which the sellers represent as quite valuable. Consequently, an analysis was conducted of this intangible asset:

Backlog is defined as 0% complete finished goods when no portion is in the work-in-process state. Using the market approach to determine the FMV of XYZ's backlog, the following formula is applicable:

Net sales value of backlog Minus: Expected costs to complete and dispose of the

backlog Equals: Proceeds before profit allowance Minus: Profit allowance to the purchaser of the foundry's

backlog Equals Fair market value of the backlog

Net sales value of the backlog is based on the expected average selling price of the orders in XYZ's backlog. The cost to complete the backlog is calculated on the actual historical relationship of the cost of sales to net sales. The

cost to complete the backlog is deducted for

expected sales proceeds.

Disposal costs represent general and administrative, distribution and other expenses

incurred during the disposal

of the backlog. In the case of products manufactured to order, selling expenses are deducted from the sales value of the backlog.

The profit allowance to the purchaser of the backlog is the amount profit that will provide the purchaser

with a return commensurate with the degree of

risk assumed, including time to complete and ship the

product and collect receivables.

At this point, the buyer began comparing results. Due to market conditions and high costs, XYZ is generating only a small return on assets. This becomes more obvious when considering the total in-use replacement costs of all assembled assets.

The income approach to determine the business enterprise value is, therefore, the ceiling figure the buyer would consider. The buyer further considers that XYZ is a private business with no ready market for its stock and that it has no other competitive bidders. The initial offer is subsequently "discounted" for this "lack of marketability" of the closely held XYZ stock.

The potential buyers are an independent investment group not currently involved in the industry. XYZ management recognizes that foundries are commonly owned by end-users.

If so, such a strategic buyer is often willing to offer a premium over the pure financial value of the stand-alone foundry as just determined. With this concept in mind, XYZ's owners decided to seek competitive bids from more compatible potential buyers.