Business valuation

Overview

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by the interested counterparties to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. Specialized business valuation credentials include the Chartered Business Valuator (CBV) offered by the CBV Institute, ASA and CEIV from the American Society of Appraisers, and the Certified Valuation Analyst (CVA) by the National Association of Certified Valuators and Analysts; these professionals may be known as business valuators. In some cases, the court would appoint a forensic accountant as the joint-expert doing the business valuation. Here, attorneys should always be prepared to have their expert's report withstand the scrutiny of cross-examination and criticism. Business valuation takes a different perspective as compared to the valuation of publicly listed company shares,

which is about calculating theoretical values of listed companies and their stocks, for the purposes of share trading and investment management. This distinction derives mainly from the use of the results: stock investors intend to profit from price movement, whereas a business owner is focused on the enterprise as a total, going concern. A second distinction is re corporate finance: when two corporates are involved, the valuation and transaction is within the realm of "mergers and acquisitions", and is managed by an investment bank, whereas in other contexts, the valuation and subsequent transactions are generally handled by a business valuator and business broker respectively.

Estimates of business value

The evidence on the market value of specific businesses varies widely, largely depending on reported market transactions in the equity of the firm. A fraction of businesses are publicly traded, meaning that their equity can be purchased and sold by investors in stock markets available to the general public. Publicly traded companies on major stock markets have an easily calculated market capitalization that is a direct estimate of the market value of the firm's equity. Some publicly traded firms have relatively few recorded trades (including many firms traded over the counter or in pink sheets). A much larger number of firms are privately held. In these firms—which include corporations, partnerships, limited liability companies, and other organizational structures—equity interests are typically traded privately and often infrequently. As a result, previous transactions offer limited insight into a private company's current value. This is because business value fluctuates over time, and share prices are subject to significant uncertainty due to limited market visibility and high transaction costs. A number of stock market indicators in the United States and other countries provide an indication of the market value of publicly traded firms. The Survey of Consumer Finance in the U.S. also includes an estimate of household ownership of stocks, including indirect ownership through mutual funds. The 2004 and 2007 SCF indicate a growing trend in stock ownership, with 51% of households indicating a direct or indirect ownership of stocks, with the majority of those respondents indicating indirect ownership through mutual funds. Few indications are available on the value of privately held firms. Anderson (2009) recently estimated the market value of U.S. privately held and publicly traded firms, using Internal Revenue Service and SCF data. He estimates that privately held firms produced more income for investors, and had more value than publicly held firms, in 2004.

Standard and premise of value

Before the value of a business can be measured, the valuation assignment must specify the reason for and circumstances surrounding the business valuation. These are formally known as the business value standard and premise of value. The standard of value is the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions, such as assuming that the business will continue forever in its current form (going concern), or that the value of the business lies in the proceeds from the sale of all of its assets minus the related debt (sum of the parts or assemblage of business assets). When done correctly, a valuation should reflect the capacity of the business to match a certain market demand, as it is the only true predictor of future cash flows.

Standards of value

Fair market value – a value of a business enterprise determined between a willing buyer and a willing seller both in full knowledge of all the relevant facts and neither compelled to conclude a transaction. Investment value – a value the company has to a particular investor. The effect of synergy is included in valuation under the investment standard of value. Intrinsic value – the measure of business value that reflects the investor's in-depth understanding of the company's economic potential.

Premises of value

Going concern – value in continued use as an ongoing operating business enterprise. Assemblage of assets – value of assets in place but not used to conduct business operations. Orderly disposition – value of business assets in exchange, where the assets are to be disposed of individually and not used for business operations. Liquidation – value in exchange when business assets are to be disposed of in a forced liquidation. Premise of value for fair value calculation

In use – if the asset would provide maximum value to the market participants principally through its use in combination with other assets as a group. In exchange – if the asset would provide maximum value to the market participants principally on a stand-alone basis. Business valuation results can vary considerably depending upon the choice of both the standard and premise of value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would determine the fair market value of a business asset that would compete in the market for such an acquisition. If the synergies are specific to the company being valued, they may not be considered. Fair value also does not incorporate discounts for lack of control or marketability. However, it is possible to achieve the fair market value for a business asset that is being liquidated in its secondary market. This underscores the difference between the standard and premise of value. These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.

Economic conditions

A business valuation report generally begins with a summary of the purpose and scope of business appraisal as well as its date and stated audience. Following is then a description of national, regional and local economic conditions existing as of the valuation date, as well as the conditions of the industry in which the subject business operates. A common source of economic information for the first section of the business valuation report is the Federal Reserve Board's Beige Book, published eight times a year by the Federal Reserve Bank. State governments and industry associations also publish useful statistics describing regional and industry conditions. Valuators use these as well as other published surveys and industry reports. The net present value (NPV) for similar companies may vary depending on the country because of the different time-value of money, country risk and risk-free rate.

Financial analysis

The financial statement analysis generally involves common size analysis, ratio analysis (liquidity, turnover, profitability, etc.), trend analysis and industry comparative analysis. This permits the valuation analyst to compare the subject company to other businesses in the same or similar industry, and to discover trends affecting the company and/or the industry over time. By comparing a company's financial statements in different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in capital structure, or other financial trends. How the subject company compares to the industry will help with the risk assessment and ultimately help determine the discount rate and the selection of market multiples. It is important to mention that among the financial statements, the primary statement to show the liquidity of the company is cash flow. Cash flow shows the company's cash in and out flow.

Normalization of financial statements

The key objective of normalization is to identify the ability of the business to generate income for its owners. A measure of the income is the amount of cash flow that the owners can remove from the business without adversely affecting its operations. The most common normalization adjustments fall into the following four categories:

Comparability adjustments. The valuer may adjust the subject company's financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company's data is presented in its financial statements. Non-operating adjustments. It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market value standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet. Non-recurring adjustments. The subject company's financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management's expectations of future performance. Discretionary adjustments. The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner's compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company's owners individually may be scrutinized.

Approach to valuation

Three different approaches are commonly used in business valuation: the income approach, the asset-based approach, and the market approach. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Generally,

the income approaches determine value by calculating the net present value of the benefit stream generated by the business (discounted cash flow); the asset-based approaches determine value by adding the sum of the parts of the business (net asset value); and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region. However, many small businesses will use the Seller Discretionary Method as a practical, simple method of business valuation. This approach can then be blended with the income, asset-based, and market approaches for a robust valuation analysis. A number of business valuation models can be constructed that utilize various methods under the three business valuation approaches. Venture Capitalists and Private Equity professionals have long used the First Chicago Method which essentially combines the income approach with the market approach. In certain cases equity may also be valued by applying the techniques and frameworks developed for financial options, via a real options framework, as discussed below. The valuation approach may also differ by industry and / or given the business context. In determining which of these approaches to use, the valuation professional must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics is helpful.

Valuation

The various approaches to valuation are detailed in the following sections. See also Valuation (finance) § Business valuation.

Income approach

The income approach relies upon the economic principle of expectation: the value of business is based on the expected economic benefit and level of risk associated with the investment. Income based valuation methods determine fair market value by dividing the benefit stream generated by the subject or target company times a discount or capitalization rate. The discount or capitalization rate converts the stream of benefits into present value. There are several different income methods, including capitalization of earnings or cash flows, discounted future cash flows ("DCF"), and the excess earnings method (which is a hybrid of asset and income approaches). The result of a value calculation under the income approach is generally the fair market value of a controlling, marketable interest in the subject company, since the entire benefit stream of the subject company is most often valued, and the capitalization and discount rates are derived from statistics concerning public companies. IRS Revenue Ruling 59-60 states that earnings are preeminent for the valuation of closely held operating companies. However, income valuation methods can also be used to establish the value of a severable business asset as long as an income stream can be attributed to it. An example is licensable intellectual property whose value needs to be established to arrive at a supportable royalty structure.

Discount or capitalization rates

A discount rate or capitalization rate is used to determine the present value of the expected returns of a business. The discount rate and capitalization rate are closely related to each other, but distinguishable. Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.

In DCF valuations, the discount rate, often an estimate of the cost of capital for the business, is used to calculate the net present value of a series of projected cash flows. The discount rate can also be viewed as the required rate of return the investors expect to receive from the business enterprise, given the level of risk they undertake. On the other hand, a capitalization rate is applied in methods of business valuation that are based on business data for a single period of time. For example, in real estate valuations for properties that generate cash flows, a capitalization rate may be applied to the net operating income (NOI) (i.e., income before depreciation and interest expenses) of the property for the trailing twelve months. There are several different methods of determining the appropriate discount rates. The discount rate is composed of two elements: the risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, such as a high quality government bond; plus a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied. Capitalization and discounting valuation calculations become mathematically equivalent under the assumption that the business income grows at a constant rate. Once the capitalization rate or discount rate is determined, it must be applied to an appropriate economic income stream: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings, projected cash flow, etc. The result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches. Careful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy of the business valuation results. Net cash flow is a frequent choice in professionally conducted business appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the build-up, or CAPM, models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. At the same time, the discount rates are generally also derived from the public capital markets data.