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.
Under the fair market value standard, the hypothetical buyer is assumed to be a purely financial buyer seeking a return on the investment. The “financial buyer” lacks synergies or strategic benefits associated with the transaction. As a result, the fair market value estimate is typically lower than the “strategic value” estimate, which is based upon the price that encompasses synergies or strategic benefits that could be obtained through the acquisition. Therefore, the price that a strategic buyer typically is willing to pay for the company is equal to the fair market value estimate plus the value of any synergies associated with an acquisition of the company.
To arrive at the fair market value estimate, the business valuation professional (or “appraiser”) must examine a number of factors associated with the company such as its history, financial condition, earnings capacity, dividends, industry and economic conditions, etc. The appraiser may also make adjustments to the financial statements of the closely held and family controlled company to remove any non-recurring items or perquisites to the owners. Adjustments are also made to remove any real estate owned by the company that should be appraised separately by a real estate appraiser. These adjustments are made, when reliable estimates are available, to adjust book values to market values and to provide a value based on future earnings that would not include controlling decisions regarding discretionary expenses. These factors are then incorporated into the overall analysis of the company to determine the value drivers as well as specific company risk factors that may have an impact on the value of the company.
There are various approaches for business appraisers to utilize in determining the value of a business. Each approach has various methodologies that can be employed to determine the value of a business. The appraiser must then select the appropriate approaches and methods to apply to the company’s specific conditions to arrive at an indication of value. The approaches that the business valuation professional may consider include:
- Income Approach—The Income Approach derives an indication of value based on the sum of the present value of expected economic benefits associated with the company. Under the Income Approach, the appraiser may select a multi-period discounted future income method or a single period capitalization method.
The capitalization method estimates the fair market value of a company by converting the future income stream into value by applying a capitalization rate incorporating a required rate of return for risk assumed by an investor, along with a factor for future growth in the earnings stream being capitalized. This results in a value based on the present value of the future economic benefits that the buyer will receive through earnings, dividends, or cash flow. The capitalization method uses a single period proxy of future earnings to determine the present value of the asset. This method is usually employed when a company is expected to experience steady financial performance for the foreseeable future and when growth is expected to remain fairly constant.
Multi-period discounted future income methods involve discounting a projected possible future income stream on a year-by-year basis back to a present value using an appropriate discount rate that reflects the required rate of return on the investment (compensating for risk). For the final year of the projection period, the income stream that represents the expected income stream in perpetuity is capitalized to arrive at a “terminal value,” which is then discounted back to a present value (at the same discount rate) and added to the present value of the prior years’ income streams to arrive at the indication of fair market value.
This multi-period method is most commonly used when the company is expected to experience a period of abnormal growth or when the growth rate for the near-term is anticipated to be significantly different from the long-term rate of growth. This is predicated upon the ability to create a reasonable forecast of the company’s income stream for the forecast period. If these conditions are satisfied, the multi-period discounted future income method may more reliably capture the value impacts of cyclicality or abnormal short-term factors impacting the company’s results than a capitalization method.
- Market Approach—The market approach derives an indication of value by comparing the company to other similar companies that have been sold in the past. The “guideline publicly traded company method” uses the prices of similar and relevant public companies as guidelines for determining the value of a closely held or family controlled business. The “direct market data method” relies on transaction data of similar closely held and family controlled businesses to determine an indication of value.
The premise of this approach is based on the economic principle of substitution stating that one will not pay more for an asset than the amount at which they can acquire an equally desirable substitute. The market price of stocks in corporations having their shares actively traded in a free and open market can be an indication of value when the transactions in such freely traded companies are sufficiently similar to the company being valued to permit a meaningful comparison.
Guideline company transactions in the open market may involve either minority or controlling interests in the guideline companies. To be sufficiently similar to the company being valued, however, the guideline company must exhibit similar factors such as:
- Investment characteristics,
- Business size,
- Markets served,
- Depth of management,
- Probable future earnings expectations.
Relevant factors to be considered focus on the characteristics of the willing buyer and include:
- Risk tolerance,
- Degree of owner involvement in management of the company,
- Expected holding period.
The guideline publicly traded company method is appropriate when similar and relevant proxy companies may be identified and employed in estimating the value of a closely held and family controlled company.
The direct market data method develops an estimate of value for the subject company through use of transactional information on actual sales of a large sample of closely held companies. Sources of transactional data may include databases such as The Institute of Business Appraisers (IBA) Transaction Database, Pratt’s Stats, DoneDeals, Bizcomps, etc. Though similar to the guideline publicly traded company method, there are several major differences that distinguish the two methods.
Under the guideline publicly traded company method, a small number of companies are selected as being similar to the company being valued. They and their stock prices are compared to the company being valued to arrive at a valuation estimate. The direct market data method, however, assumes that the sample of transactions for which market data is obtained represents the statistical population of the market for similar businesses as the one being valued. The company is then compared to the market based on its relative strengths and weaknesses with respect to financial condition, performance, etc. The market value of the company is then estimated based on the prices at which other companies have sold.
The direct market data method is usually employed when there is a large enough sample of transactional data of similar and relevant companies to develop a reliable indication of value.
- Asset Approach—The Asset Approach adjusts a company’s assets and liabilities to their fair market values and adds to the Balance Sheet the value of intangible assets and any contingent liabilities. While tangible assets can be appraised and reported on an adjusted Balance Sheet accordingly, the valuation of intangible assets such as reputation, employee talent, etc. is more complicated.
One method of deriving an indication of value under the Asset Approach is the excess earnings method. The excess earnings method is a hybrid of the Asset and Income Approaches. The excess earnings method requires the valuation of both tangible and intangible assets then deducting the company’s liabilities in order to determine the fair market value of a company.
The adjusted book value method adjusts the company’s assets and liabilities to market values to develop an indication of value. This method assumes the underlying assets are the relevant factor in determining the fair market value of the company. This method ignores future earnings potential and assumes the company has no good will.
The business valuation professional may determine that the Asset Approach is inappropriate for determining an indication of value for a number of reasons. For example, the excess earnings method is often not employed as the rates of return are arbitrary.
After selecting the appropriate approaches and methods, the appraiser typically adjusts the value indications to reflect the relative lack of marketability of closely held businesses as compared to liquid and readily marketable public counterparts. The values calculated based on the various methods are then reconciled to provide an indication of value or an estimated value range for the company.
Business valuation can be a bit of a dry and technical topic. However, this provides entrepreneurs with an overview of the basic methodology used by appraisers in most company valuation scenarios, so that it doesn’t look like a “black box.” To be sure, when analyzing a startup and early-stage companies, a great deal of adjusting and intuition/judgment are necessary to estimate company values.