The justification of purchase (“JOP”) test requires that the business, if purchased for the indicated amount:
1. Can pay the owner-manager reasonable (fair market) compensation.
2. Can adequately service assumed and acquisition debt.
3. Can earn a satisfactory return on investment. (This applies only to businesses that are not “buy-a-job” entities.)
A colleague called because his JOP test was not working out, although he was sure he had reasonable assumptions and his math was correct. To make a long story short, the problem arose because of non-operating assets, in this case a hefty excess cash balance.
My colleague was subjecting the value of the equity INCLUDING THE EXCESS cash to the JOP test. The indicated rate of return on this basis was LESS than the cost of equity capital.
The JOP only considers the OPERATING ASSETS AND LIABILITIES of the business. Non-operating assets should be excluded from it. These (in this case, the excess cash), are not expected to earn a hefty return; bank deposits pay only about 1% as this is written; they are valued separately (outside of the JOP).
If you are using the Asset Approach to value a business, there is no JOP. The assets and liabilities are independently valued. If you are using the Income or Market Approach, use only the operating assets and liabilities as your justifiable value.