Business valuations (BV) are conducted by certified public accountants or other accredited and trained professionals who have expertise in determining the value of a business. The process is part art, part science, and requires some assumptions and professional judgement. Because of the nuances and complexities of these types of engagements, there is no specific formula or “one-size-fits-all” method.
BVs are typically used when companies are involved with:
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Transactions (buy/sell)
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Succession or exit planning
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Mergers and acquisitions
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Litigation and disputes
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Needs related to financial reporting under U.S. Generally Accepted Accounting Principles (GAAP)
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Matters regarding employee stock ownership plans (ESOPs)
If you think that a “quick look at the books” can determine a business’ value, you’ll want to read this article.
What is a business valuation?
A business valuation involves a review of a business’s tangible and intangible assets, cash flow, and capital appreciation, and assigning a fair market value to them. The goal of a valuation is to determine what someone is willing to pay, in today’s dollars, to receive future financial benefits from a business.
Let’s define the two types of 1assets:
Tangible assets
Tangible assets include property, equipment, furniture, inventory, and vehicles. Financial securities, such as stocks and bonds, are also considered tangible assets because they derive value from contractual claims. Tangible assets can be current, easily converted to cash (inventory), or fixed with a lifespan of one year or more (plant, property, and equipment [PP&E]).
Intangible assets: indefinite and definite
An indefinite intangible asset lasts as long as the holder operates, like a brand name. A definite intangible asset has a set period of use under a legal agreement, such as using another company's patent, intellectual property, trademark or copyright. During a transaction these assets are called goodwill. Those that fall under a legal agreement need authorization from the seller to use.
Business Valuation: The process
Appraising the business
2Standards of value
Standards of value provide context that helps the professional analyze the business. There are numerous different types of standards of value, some of which are defined below with examples of when they may be used.
- Fair Market Value (FMV)
According to IRS Revenue Ruling 59-60, FMV is "the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."
FMV is used most often in valuations for gift, estate, and income tax matters, and in litigation and buy-sell agreements. It can provide an indication of the value (or range of values) at which a business might sell, but it's not intended to provide an actual transactional value.
- 3Investment (or Strategic) Value
Investment value is the value to a particular investor based on individual investment requirements and expectations. For example, a buyer-specific rate of return might be used to determine the price to pay for the business's expected stream of cash flows.
- 4Fair Value (State Rights)
Fair Value under State Rights refers to a judicially determined, statutorily defined value of a minority shareholder's interest, specifically excluding discounts for lack of control or marketability that would typically be applied in a Fair Market Value appraisal.
This standard is used in legal contexts like appraisal rights in mergers or shareholder disputes to ensure minority shareholders forced out of a company receive their proportionate share of the business's intrinsic value.
- Fair Value (Financial Reporting Standard)
This standard of value is used by businesses in reporting the values of assets in accordance with U.S. GAAP. For example, this standard of value is used in business combinations to allocate purchase prices on the books of acquiring companies.
- Intrinsic Value
3Intrinsic value is the value that an investor considers on the basis of an evaluation or available facts to be the true, real or fundamental value that will become the market value when other investors reach the same conclusion. This standard isn't often seen in practice when valuing private business interests. It's used primarily by investment analysts to seek out the fundamental price of a publicly traded security.
Engagement Considerations
Along with the chosen standard of value, there are additional considerations that need to be defined in order for the appraiser to determine how to go about analyzing the subject interest being valued. These include but are not limited to: determinations about whether there is minority or controlling interest; voting or non-voting stakeholders; or the possibility of a swing vote, which occurs when a small ownership interest is held by a third party, and the remaining ownership is divided almost equally between two other parties. The appraiser may also factor in any restrictions on transfers of an ownership interest, or the fact that an interest in a privately-held company cannot readily be sold and converted to cash in a relatively short time frame. This type of characteristic is often referred to as a lack of marketability and in certain instances, can have an impact on value.
Additionally, the defined standards of value can provide context on what factors may contribute to the ultimate conclusion of value. For example, when using Fair Market Value (IRS RR 59-60), factors considered include:
- Nature and history of the company
- General and specific economic outlook
- Book value (value of a company's assets after deducting its liabilities) and financial condition of the business
- Earnings and capacity of the company
- Goodwill or other intangible value
- Market price of similar publicly traded securities
- Marketability of the securities
- Control premium (an amount a buyer is willing to pay in excess of the fair market value of shares in order to gain a controlling interest in a company)
Methods to assign value
Three of the most accepted methods of business valuation include the income approach, the market approach, and the adjusted net asset value method.
Income Approach
The income approach analyzes potential economic benefits such as earnings before interest, taxes, depreciation and amortization (EBITDA), net income, and cash flow, and considers the risk associated with these benefits. The income approach is theoretical and widely accepted in the valuation community but includes some subjective assumptions.
Within the income approach, there are two main valuation methodologies:
- Capitalized Earnings Method (CE): Appropriate when a company’s current level of operations is believed to be representative of future operations and is expected to grow at a stable rate and in line with the economy.
- Discounted Cash Flow Method (DCF): Appropriate when the business operations are not considered stable or future operations are expected to grow at widely varying or rapidly increasing rates. Realistic management projections for future periods are necessary for this methodology.
When using the income approach, the risk of a subject interest is considered in determining an appropriate discount rate (a rate of return used to convert a future monetary sum into present value) or capitalization rate (any divisor used to convert anticipated economic benefits of a single period into value). There are different approaches for determining these rates, including the Capital Asset Pricing Model (CAPM) and the Build-Up Method. All methods include some subjectivity in quantifying the appropriate inputs while other inputs may be somewhat standardized. The inverse of a discount or capitalization rate is the multiple.
Overall, the discount or capitalization rate represent the amount of return that a hypothetical investor would need to earn to invest his or her money in this interest versus other potential investments with the same risk characteristics.
Market Approach
The market approach involves using either publicly traded data or private company transaction data to derive appropriate pricing multiples. This approach can be used for minority or controlling interests. Market data involving actual transactions is used to value the company, but it can be difficult finding timely and comparable companies. This approach is similar to how a real estate appraiser values a property, by looking at the sale price of other parcels in the general area to determine a baseline and then potentially adjusting for other specific characteristics.
Court cases have specified certain factors that can be utilized in determining comparable companies. They include: products, markets, management depth, earnings, position of the company in its industry, capital structure or credit status, and competition.
Adjusted Net Asset Value Method
The adjusted net asset value method adjusts all individual assets and liabilities to fair market value. This value represents the amount a controlling owner could liquidate for a Controlling Interest Basis, without consideration of liquidation or transaction costs.
The adjusted net asset value method is good for holding companies, those that are capital asset intensive, or poor performers. However, this method fails to account for any of the company’s intangible assets, and it does not focus on income generated. Business owners who pursue a valuation using the adjusted net asset value method may need real estate or machinery and equipment independently appraised.
As you can see, a BV is a complex process that can take between three and six months to complete. There are no shortcuts or one-size fits all formula, but rather in-depth research, discussion amongst the Business Valuation team and client, conversation with external sources, capital market and private deal transaction databases are the standard.
Sources:
3 NACVA