Business Valuation Is More Art Than Science

How Much Is Your Business Worth?

You need both your right and left brains when performing a business valuation. Valuing a company is an endeavor that is mostly science, with a bit of art added in. To begin, one must understand the three principal methods of valuation and the different ways to apply them, with each requiring some judgment calls from valuation experts.

Ultimately, a business valuation is an attempt to estimate the market value of a business. Market value is defined as the price point at which a transaction occurs between a buyer and a seller, both having all relevant facts and neither being under compulsion to buy or to sell.

The oddity with any market price is that each party believes they are smarter than the other. When multiple parties come together with different views of the industry environment and the particular company, the value of that company becomes a subjective matter.

Valuing a Company in Three Methods

In the context of business valuation, there are three valuation approaches: income, market, and cost.

Income

The income approach considers the future earnings and cash flow capacity of a business to determine a present value. This approach is most commonly executed using a ‘Discounted Cash Flow’ analysis (DCF), which adheres to the following structure:

• Step 1: Estimate the future cash flows over a discrete period. The discrete period should reflect whatever is required until the business can operate in a normalized state. Many valuation practitioners consider a five-year period, although this can vary based on the circumstances of the business.
• Step 2: Discount the discrete period cash flows using an appropriate cost of capital, which is the rate of return required by a hypothetical investor to attract investment in the business.
• Step 3: Add a terminal value that reflects the value of the business after the discrete forecast period. The terminal value can be determined through a financial estimation that involves the cost of capital and long-term growth rate or through the application of a valuation multiple to a terminal year financial measure. In other words, practitioners estimate the value of the business as it expects to operate in perpetuity.

At each step throughout the income approach, there are key areas of judgment:

Discrete Period Forecast

The forecast should consider the outlook of the business, economy, and industry to assess projected impacts on revenue, operating and tax expenses, and other cash flow items.With any forecast, the only certainty is in its inaccuracy. Clearly, when looking toward the future, there will be significant judgments, and the actual performance will always differ from the expected performance.

In addition, when preparing a forecast, you should consider how a hypothetical buyer might view the company. For example, private companies might include discretionary expenses, such as automobiles, private planes, and excessive salaries. These are expenses that a third-party would not have in its expense structure. Scouring the financial statements for unusual or unnecessary expenses is an important step in valuing a business, and valuation practitioners often disagree on the adjustments to be made.

Many strategic buyers will also consider the value associated with their expected synergies, which might include cost savings from eliminating redundancies or expected revenue enhancements due to complementary product or service offerings. Often, in competitive bid situations among such buyers, some or all of the expected synergistic value will be included in their valuations.

Discount Rate (Cost of Capital)

The discount rate is the rate used to discount future cash flow to determine its present value. The rate is used to see if the value will meet or exceed the cost of capital or the return to achieve a positive investment.

When estimating the cost of capital, assumptions such as market returns, industry risk factors, capital structure, and cost of debt must be made. Although valuation practitioners look at market data, there is still subjectivity in selecting guideline companies and data points.

Terminal Value

The terminal value is the cash value beyond the forecasted period.

In estimating a terminal value, the main areas where valuation practitioners may differ is in the selection of a valuation multiple or a long-term growth rate. The difficulty with using a multiple to estimate terminal value is that you are attempting to estimate an earnings figure that is often five years or more into the future.

In observing multiples of guideline companies, know that they’re largely impacted by near-term expectations and may not be appropriate for application to a future earnings measure. Likewise, selecting a long-term growth rate is inherently subjective. When using terminal value to estimate, you should consider the long-term economic and industry outlook.

Market

The market approach benchmarks market prices of either similar publicly traded or acquired companies and applies that pricing to the company through the use of multiples. This approach is most often executed using two similar methodologies: the ‘Guideline Company Method’ and the ‘Guideline Transaction Method.’

The Guideline Company Method involves obtaining market information for publicly traded companies that are considered to be similar to the company. Using this data, valuation practitioners then compute various market multiples, which can include:

• Enterprise Value/Revenue
• Enterprise Value/EBITDA
• Enterprise Value/Earnings before interest and taxes (EBIT)
• Equity Value/Net Income (Price-to-Earnings)
• Equity Value/Book Value of Equity

Multiples such as these can be computed for the guideline companies across various time periods and then applied to the corresponding financial measure for the subject company.

While ‘Enterprise Value/EBITDA’ is the most commonly applied metric to a profitable operating company, other multiples may often be more applicable based on specific facts and circumstances. For instance, banks are commonly valued based on equity value multiples, whereas early-stage technology companies are valued on run-rate revenue multiples. In other situations, multiples may be estimated based on operating metrics as opposed to financial metrics. For instance, certain healthcare facilities could be considered on a ‘per-bed’ basis.

The Guideline Transaction Method shares many similarities with the Guideline Company Method. However, rather than considering the price of similar publicly traded companies, this approach considers the available information related to companies that have been acquired. Multiples of revenue, EBITDA, EBIT, and other elements are calculated and applied to the corresponding financial measures of the subject company.

Cost

The cost approach takes into account the value of all of the underlying assets and liabilities of the business. It is not typically used in the valuation of an operating business, as it’s difficult to assess the intangible values without first valuing the overall business. This approach is, however, often considered for asset holding companies such as real estate holding companies,  where it can be used to determine a floor value.

Making Judgment Calls

Valuation practitioners will often disagree on the various aspects of a market approach. These aspects can include the selection of guideline companies, multiples, and assessment periods. Adjustments to the market multiples and the earnings measures should account for differences between public guideline companies and the subject company.

You should also be aware that the guideline companies may be more mature businesses and have lower growth outlooks than the subject company. Someone may increase the market multiple applied to the subject company to account for its enhanced growth prospects. Adjustments could also be made for variables such as risk, asset intensity, tax differences, and non-operating assets. These adjustments leave significant room for judgment.

When applying the Guideline Company Method, the application of a control premium to the indicated value of private companies is a factor that is debated within the valuation community. The control premium attempts to account for several variables inherent in valuation via stock. The stock prices of publicly traded companies reflect the price paid for a single share of stock, where the owner has no effective control over the operations of a company.

Additionally, when public companies are acquired, the price paid is typically a premium to the current market price for a single share. Some of this premium may reflect the buyer’s ability to exercise control over the business and its cash flows. If you’re using multiples that are generated from publicly traded guideline companies, the multiples and indicated values represent the value of a single share or minority shareholding. If you are valuing 100%, or a controlling interest, in a private company, the application of control premiums remains a significant element of judgment that impacts estimated values.

If applying the Guideline Transaction Method on the other hand, you may be required to make a variety of judgment calls due to the subjective nature of guideline company transactions, multiples, multiples adjustment, and limited access to information regarding acquired companies.

The income and market approaches require subjective judgments practitioners make based on their experience and knowledge. By utilizing multiple approaches, practitioners can estimate the value of the subject company with added confidence. In the end, the subjective nature of a business valuation will always make the exercise more of an art than a science.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Selecting the Right Valuation Expert
2. How to Read a Balance Sheet – And Why You Care!
3. EBITDA and Other Scary Words

This is an updated version of an article originally published April 23, 2019 and updated July 1, 2021.]

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