Business valuations are used for a variety of purposes: in transactions, for financial and retirement planning, for taxation, and in connection with litigation. A valuation can be as loose as a guess, to a ‘back of the envelope’ calculation, to a formal opinion rendered by a third-party professional business valuation expert. Although a valuation is commonly considered to be ‘part science, part art’; experts utilize sound financial and time-tested methodologies.
The purpose of a business valuation determines the appropriate approach and methodology to be applied to opine value. As a seller, you quite likely will want an expert business valuation opinion. Although your need to understand “how the sausage is made” will be limited, you should at least have a basic understanding- if for no other reason so that you can decide if you want one and, if you do, to help you ask the right questions as you interview experts before hiring one.
Essentially, there are three recognized approaches to value:
Under each approach there are common methods for estimating the value of a business.
The market approach is based on the principle of substitution. The fundamental basis of this approach is predicated on the theory that the fair market value of a closely-held company can be estimated based on the prices investors are paying for the stocks of similar, publicly traded (or private) companies. This is done through the use of ratios that relate the stock prices of the public companies to their earnings, cash flows, or other measures. By analyzing the financial statements of analogous companies and then comparing their performances with those of a subject company, the appraiser can judge what price ratios are appropriate to use in estimating the market value of the closely-held entity.
Methods under the market approach include:
From these methods, value is determined through market multiples of either publicly-traded or privately-held companies.
The Dividend-Paying Capacity Method and the Guideline Company Method use financial and market information gleaned from publicly-traded securities of companies engaged in business pursuits similar to those of the subject company. The premise of this data assumes that prevailing investor attitudes and expectations can be applied to ascertain value for the subject company. Differences in the comparable companies are noted and adjustments are made to develop appropriate market multiples which can be applied to the subject company’s income and cash flow streams to develop value indications.
When using the Guideline Merged & Acquired Company Method or the Transaction Database Method for business valuation, market multiples from transactions involving privately-held companies within the same or similar industry are applied to the subject company’s level of economic income.
Market methodology may be applied as a sanity check to other values derived, such as those from an income approach methodology. However, a market approach also allows the valuation analyst, and/or users of a business valuation opinion, to examine how the marketplace reacts to companies within the same or similar industry as the subject company, based on varying levels and types of economic incomes. For example, examination of market multiples may give a perspective on the types of buyers, demand, and rates of return for a given entity in a given industry.
The income approach is based upon the economic principle of expectation. This approach assumes the value of the business is the present value of the economic income expected to be generated. Expected returns on an investment are discounted or capitalized at an appropriate rate of return to reflect investor risks and hazards. From a theoretical perspective, enterprise value is based either on historical earnings or future cash flows.
Methods under this approach include:
The Capitalization of Excess Income Method of business valuation is also known as the Internal Revenue Service (IRS) Treasury Method, and the basis of this method is that the total value of a closely-held business is the sum of the net assets and the value of the intangible assets. This method is a hybrid approach methodology (either considered an asset method or an income method), in that a company’s value may be determined on both its adjusted book value as well as its earnings capacity. The determination of the value of the intangible assets of the business is made by capitalizing the earnings of the business which exceed a “reasonable” return on the net assets of the business.
The Capitalized Economic Income Method is used widely when valuing small to medium-sized, closely-held businesses and in some cases, depending on the purpose of the valuation, larger entities. The premise of this method assumes a company’s historical results are expected to continue into the future with a relatively stable growth rate. In many cases, particularly in the case of a smaller closely-held business, plans for expansion and growth do not exist or are not formally documented. Typically with smaller companies, the future mimics history, and shareholder expectations are not as focused on future financial performance or return on investment as they are on day-to-day operations.
The Discounted Cash Flow Method (“DCF”), also referred to as the Discounted Economic Income Method, identifies the total value of a business as the present value of its anticipated future earnings, including the present value of a terminal value, in a specified period. The present value of anticipated future cash flows are discounted at an appropriate present worth factor that reflect¬s the risk inherent in the investment. This method is often utilized when valuing companies for sale, acquisition, or to acquire capital infusion. It is also employed when valuing a company that is projected to experience significant growth or has a finite life.
For example, start-ups, companies that anticipate growth based on a business plan, and companies that are in a transitional phase may all warrant a forward-looking valuation analysis. Conversely, a historical performance analysis may be required for purposes of taxation, such as estate and gift, or for purposes of divorce or shareholder litigation.
Depending on the level of economic income, both the Capitalized Economic Income Method and the DCF Method can be used for either a minority/non-controlling or a majority/controlling equity interest, whereas the Capitalization of Excess Income Method typically assumes a controlling ownership if applied.
The asset approach may be applied when the benefits of operating a business do not outweigh the value that could be derived through the orderly liquidation of assets. Methods under this approach assume a controlling premise of value and include:
The Net Asset Value Method is based on the business’ assets less existing liabilities. This simplistic approach is used most commonly for a controlling interest and when valuing securities of businesses involved the development and sale of real estate, investment holding companies, and certain natural resource companies.
The Adjusted Net Book Value Method involves adjusting a company’s tangible assets and liabilities to their current fair market values. The value derived from this method represents the going concern value and assumes there is no expectation of intangible value or commercially transferable goodwill. The Adjusted Net Book Value Method also may be applied when valuing an investment or real estate entity, when all business income is attributable to personal goodwill of the owner or key person, or when the value of the net tangible assets exceeds that of the company’s value as a going concern.
By excluding an asset approach in a business valuation analysis, the financial analyst assumes that an investor would evaluate the company based upon its earnings and cash-generating potential, rather than through an appraisal of the underlying tangible assets, which would not reflect the intangible value or economic obsolescence inherent in the company. Additionally, the application of a methodology under the asset approach assumes that the level of ownership being valued is that of a controlling shareholder, as only a majority equity ownership (or a 50-plus-one vote) could dictate the company’s capital structure and, thus, the orderly liquidation of assets.
Utilizing methods under one or more of the three business valuation approaches allows for a comparison of information as a sanity check to confirm the integrity of the final value concluded. Users of valuation report information should be knowledgeable to the extent they can ask informed questions and ascertain meaningful information in return. Most importantly, it is helpful to understand that ultimately the purpose of the business valuation will determine the process and the methodology applied.
Editor’s Note: If you grasp the concepts discussed in this article, go ahead and read this one to further solidify your understanding. If you want to consider hiring a valuation expert/appraiser, you will want to read this article as well.
Since 2000, Ms. Hollis has worked with advisors and closely-held business owners for valuation needs, and has experience providing valuation advisory and economic analysis services in the areas of litigation, taxation, transactional, and planning purposes, including ESOP valuation. Erin is a Director in the Financial Opinions Group at Marshall & Stevens, a national appraisal firm.…
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