Business valuation often looks like a “black box” to those not involved in the profession of valuing companies. Entrepreneurs often ask, how do you value a business? In reality, value is a pretty simple concept. The value of any business, publicly-traded stock, or other financial asset is the sum of the present value of the cash flows expected to be generated by that investment. Today’s value is a function of the expected future net cash flows that the owner or investor can expect to obtain from ownership of that asset, discounted to present day at a risk-adjusted discount rate. Obviously, cash flows that may occur five years from now are worth less in today’s dollars due to a number of factors such as risk, the time value of money, etc.
For many purposes including tax matters and a contemplated merger or acquisition, the most common standard of value is “fair market value,” which the IRS defines in Revenue Ruling 59-60 as:
…[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts…the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.