Business Valuation Basics: 2020 Guide
Posted by Valentiam Group on June 1, 2020
Business valuation follows a complex set of rules and requires knowledge of valuation techniques, factors driving value in the industry, laws and accounting standards, and a good understanding of the subject company; it also requires professional experience and good judgement. In a previous article, we discussed some of the basics of business valuation—the “rules of thumb” most important in compiling an accurate valuation. In this article, we’ll examine all the important elements of business valuation from start to finish.
Business Valuation: A Complete Guide To The Basics
Though business valuation guidelines are straightforward, valuation of business assets or enterprises requires a great deal of detailed information, as well as a number of judgement calls on the part of the evaluator. (Tweet this!) An accurate, defensible valuation relies on all of the following valuation basics.
Understanding The Purpose Of The Valuation
The reason for doing the valuation will determine the standard of value to use, and in turn, the valuation approach and the assumptions made in calculating the valuation. Each of these business valuation factors has an impact on the ultimate assessment.
There are a variety of reasons for valuing a business or business assets:
- Sale of the business or a share of the business
- Business merger or acquisition
- Tax purposes
- Financial reporting
- Marital dissolution
The purpose for the valuation will determine the standard of value to apply. For example, in a marital dissolution case, some states use a fair market value standard, while others use fair value—a statutory standard that is not determined by the current market. To further complicate matters, the fair value standard used for financial reporting purposes under Generally Accepted Accounting Practices (GAAP) varies slightly from the fair value standard used for other purposes; under GAAP guidelines, fair value is based on participants in the most advantageous market—rather than the open, unrestricted market—which tends to result in higher values. A valuation for U.S. tax purposes, on the other hand, requires application of the fair market value standard.
Identifying the purpose for the valuation and selecting the proper standard of value to use is critical to arriving at a fair, reasonable, and defensible value.
Determining The Basis Of Value
The basis of value is a consideration of the type of value being measured and the perspectives of the parties to a transaction. Is the basis of value defined as the value between a willing buyer and a willing seller, or as the investment value to the current owner? The basis of value is often specified by law, regulation, or contract, and may be the reason for pursuing the valuation. Thus, the purpose for the valuation and the basis of value are directly linked, and the basis of value will have an impact on the valuation approach used and the assumptions made in the valuation.
Determining The Premise Of Value
The premise of value is determined by the purpose for the valuation and the basis of value. Generally, it will fall into one of the following categories:
- Going concern premise: This premise of value assumes continued use of the business assets and continuing operation of the company.
- Orderly or forced liquidation premise: In this valuation premise, the assumption is that the business assets will be operated or sold individually or as a group; the company will not continue operation.
In addition, a business or asset might be of greater value to a particular buyer; this is often the case in mergers and acquisitions. In these types of transactions, acquisition of the business may allow the purchaser to expand into new markets or achieve some type of synergy that offers value above and beyond the fair market value of the acquired business. A random buyer on the open market would not realize these benefits, so for that buyer, the value of the business would be less. The premise of value for a merger or acquisition might be substantially higher as a result.
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Reviewing The Historic Performance Of The Business
Understanding the company’s history, ownership structure, and past financial performance is crucial for establishing how the business has performed relative to similar businesses. A solid understanding of these factors allows comparison of the subject company’s performance to the business valuation data of others in the same industry of similar size and age.
By comparing the price-to-earnings (P/E) ratio, sale prices for recent transactions involving similar companies, price-to-book, and price-to-free cash flow of comparable businesses to the same metrics for the Subject Company, performance of the subject company relative to similar companies can be established.
Determining The Future Outlook For The Business
Future outlook is the primary concern for an investor or purchaser; value, in their eyes, derives from the future prospect of creation of additional value. To determine future value, it’s necessary to first understand the company’s current strategy and how it has performed to date. From this understanding, it’s possible to make projections and forecasts of future revenues, market share, operating expenses, taxes, capital requirements, and cost of capital. Comparison of these metrics to those of other companies in the industry offer additional insight into the Subject Company’s future prospects.
To derive reasonable forecasts from this data, it’s also necessary to understand management’s plan for ongoing value creation in the Subject’s business and assess whether it is plausible. Does it rely on repeating strategies that have been successful in the past, or on taking a new strategic direction? Will it be generated organically, or through acquisitions? These plans must be carefully scrutinized to determine whether or not they are realistic; business expectations that deviate significantly from past performance should signal the need for additional scrutiny to determine their plausibility. For example, if management projects a rate of growth that exceeds the rate of growth of the overall economy for the infinite future, that is not a realistic assumption.
Determining The Valuation Approach To Use
Once the purpose and proper standard of valuation, the premise of value, and the business’ historic performance and future outlook are established, the best approach for calculating value can be selected. In all valuations, there are three basic business valuation approaches: the market approach, the income approach, and the cost approach.
1. Market Approach
Two market approaches can be used in valuing a business.
The first approach involves finding comparable companies and analyzing their value indicators (multiples), averaging the value indicators of the comparable companies, and applying those averages to the Subject Company. It’s an imprecise measurement, since the market may over or under value the companies used for comparison, and because the difference in multiples between similar companies may be due to company-specific factors.
The second approach is analogous to the use of comparables in real estate appraisal. Sales analysis of similar businesses provides a ballpark value; by analyzing recent sales or asking prices and making adjustments from those to account for differences from the Subject Company, a value for the company can be determined.
Limitations of this approach include limited data; the market may not provide many examples of comparable sales or offerings and independent verification of value may not be available. In addition, this approach becomes very complicated when it involves valuation of large or complex companies—there are likely to be even fewer of these to use for comparison purposes, and value for the comparable companies may include intangibles such as intellectual property, contracts, and customer relationships.
For comparison purposes, the price of the comparable company needs to be broken down into its components—tangible assets, intangible assets, real property, personal property, taxable assets, and non-taxable assets. Obtaining or determining the different elements of value is complicated, and even if they can be established, making value adjustments between the comparables and the Subject Company is a subjective judgement call.
As a result, the market approach provides useful data points, but often will not adequately reflect the Subject Company’s actual value. It is most often used in a merger or acquisition transaction, where the purchasing company hopes to realize a business synergy through the acquisition and thus is less concerned with establishing an exact value for the subject company. This approach is also commonly used in valuations for finance purposes.
2. Income Approach
The income approach is a classic approach to valuation—but it requires extensive detail and analysis and relies on many assumptions. However, it will often result in a more accurate value, particularly when combined with other valuation methods, due to the extensive analysis and detail that goes into its calculation. It allows value to be calculated using a variety of scenarios and thus can offer a range of values based on tweaks in the assumptions used for forecasting.
The value premise of the income approach is that the company’s current full cash value equals the present value of future cash flows it will generate over its remaining lifecycle.
The steps to applying the income approach are as follows:
- Estimate annual cash flows
- Convert estimated cash flows to their current cash value equivalent
- Estimate residual value at the end of the forecast period
- Convert residual value to its current cash equivalent
- Add current value of estimated cash flows to current value of residual value to calculate enterprise value
- Deduct working capital, intangible assets, and other excluded assets of the enterprise value to calculate tangible assets
While the income approach can produce a fair and defensible enterprise value, it has limitations. It does not allow separation by type of asset, so it is inappropriate for use in situations such as establishing value for property taxes. Another major limitation is that the value derived is very sensitive to assumptions about the forecast period; small changes in key assumptions such as the cost of capital can have a big impact on the calculated value. Projections are just that—guesses about what the future holds—and they may or may not be accurate. As a result, income-based valuations tend to be most accurate for companies with predictable, stable cash flows.
The income approach can be combined with the cost approach outlined in the following section, allowing for direct valuation of tangible assets and indirect valuation of intangible assets. This combined approach provides a fair and defensible value for many valuation purposes.
3. Cost Approach
The basis of the cost approach is the logic that investors will not pay more for an asset than they would for a substitute asset of equal utility. In the cost approach, the Subject Company is replicated from the ground up to determine the cost of this substitute asset.
Once the replacement cost of the company is calculated, that cost is adjusted for depreciation to arrive at the replacement value, less depreciation, of the subject company.
Generally, this will yield a value much lower than the Subject Company’s book value, because “ghost assets”—assets which exist on the company’s books, but are not used—are eliminated, as are obsolete assets.
The cost approach yields a solid capital valuation supported by current market costs and conditions; it also provides a clear value for tangible assets. When used with the income approach, intangible assets can be indirectly valued, by subtracting the value of tangible assets calculated in the cost approach from the enterprise value derived through the income approach.
The biggest drawback to the cost approach is the amount of data required for this method of business valuation. Data on the cost of materials, equipment, labor—and sometimes more—is required to arrive at the value, making the cost approach data and labor intensive.
Arriving At A Conclusion Of Value
Often, the value will be calculated using more than one approach; the resulting values are then evaluated and weighted as appropriate. Additional adjustments (discounts) are then made for marketability, which reflects the inability to quickly convert an interest in the business to cash, and control, to account for lack of complete operational and financial control, if there are minority stakeholders whose approval is required in making decisions.
These basics are the foundation of an accurate and defensible business valuation. Everything from the purpose of the valuation, the basis and premise of value assumed, and past performance and future outlook of the subject company must be taken into consideration before any of the valuation approaches are applied. The challenge in achieving a fair and accurate valuation is in selecting the most appropriate valuation approach (or approaches), accurately weighting the calculated values, and using good judgement in making adjustments. While the valuation approaches are straightforward and calculating value may appear to be simply a matter of plugging the right numbers into the right formulas, in reality, professional judgement is crucial to obtaining an accurate estimation of value for the subject assets.
Understand the basics of business valuation, but need the judgement of a professional to establish the value of your company?
Valentiam has helped companies in a variety of industries attain much more accurate enterprise and asset valuations. We have extensive experience in the application of all three valuation methods for a broad range of businesses and situations. Our valuation and transfer pricing specialists have worked with some of the largest companies in the world. Contact us to see how we can help your company with your valuation and transfer pricing needs.
Topics: Business valuation