Business valuation is governed by a complicated set of regulations that necessitates a thorough awareness of valuation methodologies, industry drivers of value, laws and accounting standards, and a thorough understanding of the subject firm, as well as professional expertise and sound judgment. We covered some of the fundamentals of business valuation in a previous post, including the most crucial “rules of thumb” for establishing an accurate assessment. From beginning to end, we’ll look at all of the main aspects of company valuation in this article.
Business Valuation: A Complete Guide To The Basics
Though business valuation guidelines are simple, valuing business assets or businesses necessitates a great deal of detailed information and a number of judgment calls on the part of the evaluator. All of the following valuation fundamentals are required for an accurate and justifiable appraisal.
Understanding The Purpose Of The Valuation
The standard of value to apply, as well as the valuation technique and assumptions used to calculate the valuation, will be determined by the rationale for the appraisal. Each of these aspects of business appraisal has an influence on the final result.
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 sort of value being measured and the viewpoints of the parties to a transaction are taken into account when determining the foundation of value. Is the basis of value defined as the difference in price between a willing buyer and a willing seller, or as the existing owner’s investment worth? The foundation of value is frequently stated by law, regulation, or contract, and may be the motivation for the appraisal. As a result, the goal of the valuation and the basis of value are inextricably intertwined, and the basis of value will influence the valuation technique and assumptions applied.
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.
Furthermore, a firm or asset may be more valuable to a certain buyer; this is frequently the case in mergers and acquisitions. In these sorts of agreements, the buyer may be able to grow into new markets or obtain some type of synergy that provides value above and above the acquired business’s fair market worth. A random buyer on the open market would be unaware of these advantages, lowering the value of the firm for that buyer. As a result, the basis of value for a merger or acquisition might be significantly greater.
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Reviewing The Historic Performance Of The Business
Understanding the firm’s history, ownership structure, and financial performance in the past is critical for determining how the company has done in comparison to similar companies. The subject company’s performance may be compared to the business valuation data of others in the same sector of comparable size and age with a strong grasp of these elements.
The performance of the subject company may be determined by comparing the price-to-earnings (P/E) ratio, selling prices for recent transactions involving similar firms, price-to-book, and price-to-free cash flow of comparable businesses to the same measures for the Subject Company.
Determining The Future Outlook For The Business
An investor’s or buyer’s major concern is the future outlook; value, in their opinion, is derived from the future potential of creating extra value. To assess future worth, first learn about the company’s present strategy and how it has fared thus far. It’s feasible to anticipate and forecast future revenues, market share, operational expenditures, taxes, capital requirements, and cost of capital based on this knowledge. These parameters may be compared to those of other firms in the sector to have a better idea of 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 method is locating comparable firms and studying their value indicators (multiples), averaging the comparable companies’ value indicators, and applying those averages to the Subject Company. Because the market may overvalue or undervalue the firms used for comparison, and because the difference in multiples across similar companies may be attributed to company-specific circumstances, it’s an imperfect statistic.
The second method is similar to how comparables are used in real estate evaluation. A rough valuation for the firm can be calculated by evaluating previous sales or asking prices and making changes to account for variances from the Subject Company.
Limited data; the market may not supply many instances of similar transactions or offerings; and independent verification of value may not be accessible are all limitations of this technique. Furthermore, when it comes to valuing large or complex companies, this approach becomes extremely complicated—there are likely to be even fewer comparable companies to use for comparison, and value for comparable companies may include intangibles like intellectual property, contracts, and customer relationships.
The price of the similar corporation must be broken down into its components—tangible assets, intangible assets, real estate, personal property, taxable assets, and non-taxable assets—in order to make a comparison. Obtaining or defining the many parts of value is difficult, and even if they can be determined, adjusting value between comparables and the Subject Company is a subjective decision.
As a result, while the market method gives useful data points, it frequently fails to fully reflect the true worth of the Subject Company. It is most commonly employed in a merger or acquisition deal, where the acquiring firm intends to achieve business synergy as a result of the acquisition and hence is less concerned with determining the subject company’s actual worth. This method is also often employed in financial appraisals.
2. Income Approach
The income approach is a traditional method of valuing a business, but it involves a lot of data and study, as well as a lot of assumptions. Due to the significant study and detail that goes into its computation, it frequently yields a more accurate value, especially when paired with other valuation methodologies. It permits value to be estimated using a number of scenarios, resulting in a range of values dependent on changes to the forecasting assumptions.
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 revenue method can result in a fair and defendable company value, it is not without flaws. It does not allow for asset separation, making it unsuitable for scenarios like determining the value of a home for tax purposes. Another significant drawback is that the computed value is very sensitive to forecast period assumptions; slight changes in critical assumptions such as the cost of capital can have a significant influence on the calculated value. Projections are just that: estimates about the future, and they may or may not be correct. As a result, income-based appraisals are most accurate for businesses that have predictable and steady 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 cost method is based on the idea that investors will not pay more for an asset than they would for a comparable alternative asset. The cost approach involves recreating the Subject Company from the ground up in order to determine the cost of this substitute asset.
After calculating the company’s replacement cost, depreciation is subtracted to get at the subject company’s replacement value, minus depreciation.
Because “ghost assets”—assets that appear on the company’s books but aren’t used—as well as outmoded assets, this will typically result in a value substantially lower than the Subject Company’s book value.
The cost method generates a reliable capital valuation based on current market costs and circumstances, as well as a clear value for physical assets. Intangible assets can be indirectly valued using the income method by deducting the value of tangible assets estimated using the cost approach from the enterprise value derived using the revenue approach.
The most significant disadvantage of the cost technique is the volume of data necessary for business appraisal. To arrive at the value, data on the cost of materials, equipment, labor—and occasionally more—is necessary, making the cost method data and labor heavy.
Arriving At A Conclusion Of Value
The value is frequently computed using many approaches, with the resulting numbers being assessed and weighted as needed. If there are minority stakeholders whose approval is required in making decisions, additional adjustments (discounts) are made for marketability, which reflects the inability to quickly convert an interest in the business to cash, and control, which accounts for a lack of complete operational and financial control.
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?
Taqeem 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.