There are many different types of valuation methodologies that may be used to generate a fair and defensible value for a firm or its assets, just as there are many different reasons for requesting a business valuation. The first step in determining the worth of a firm or commercial assets is to choose the optimal valuation technique.
When deciding the type or types of valuation to apply for a certain instance, various factors must be considered, including the purpose for the value, the industry, and the features of the unique firm. To arrive at a defensible value in many circumstances, a mix of valuation analysis approaches is required. In this article, we’ll look at the many valuation procedures that are most widely used and approved in accounting practice, as well as which ones are most suited for particular purposes.
Purpose Of The Valuation
A number of situations require determination of a company’s current economic value:
- Desire to sell the business due to retirement, divorce, or health or family reasons
- Need for debt or equity financing to underwrite expansion or address cash flow issues
- Addition of new partners or LLC members
- Sale of a share of the business by a partner or member
- Calculation of value for tax purposes
The extent of the valuation analysis will be determined by the reason for completing the valuation—is it to establish real property value for real estate tax reasons, or is it to determine the worth of the business for sale purposes? The purpose for the value will give crucial information for determining the optimal valuation analysis methodologies.
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Types Of Valuation Methods
For determining the economic worth of a firm, three primary types of valuation methodologies are typically used: market, cost, and income; each method has pros and disadvantages. In the sections that follow, we’ll go through each of these valuation approaches and the scenarios in which they’re appropriate. We’ll also look at some real-world examples from the power sector to show how each technique may be used to evaluating a certain sort of business asset.
Market Valuation Methods
There are essentially two market approaches to valuing a business.
The first method involves locating similar firms, examining price/earnings ratios and other value indicators, calculating an average, and applying it to the subject company. Due to the fact that markets may under- or over-value enterprises, this is obviously a very imperfect method of determining worth. Also, it’s difficult to say how much of the disparity in multiples between similar firms is attributable to company-specific variables.
The second method of market appraisal is similar to using real estate comparables. This method is based on a sales study of similar properties and determines full cash worth by examining recent sales or offering prices of comparable businesses. If analogous transactions are not identical to the subject business, the comparable property’s selling price is modified to account for the variances.
In our example case, a power generation plant may be valued using the market valuation method. Using the market approach might entail looking at a recently constructed plant in the same market, instead of looking for transactions, which are likely to be few and far between. If there are no comparable assets in the market, a plant that is currently under construction or has been approved for construction could be used for comparison.
Just as in real estate valuations, the comparable plants have to be adjusted to reflect the differences from the plant you are trying to value. For example, in a real estate valuation, if you are using a comparable house that has 3 bedrooms and the property being valued has 2, then the comparable house’s sales price is adjusted for the extra bedroom. The same principle applies to power plants. The asset can have a different life span; evolving environmental and public policy regulations have a big impact on value. For example, if the plant being valued is coal-fired, there can be environmental or regulatory concerns that are likely to make coal-fueled power generation unfeasible economically.
There are several drawbacks to the market approach. In many situations, the market may not be active enough to provide sales data on comparable properties, and there may not be credible sources to provide independent verification of value. For valuation of large, complex, income-producing properties, a thorough analysis of similar transactions is complicated; not only are there fewer of these transactions, but information related to the economic factors which influenced the decisions of buyers in those transactions is not available through public records. These types of transactions often include purchase of intangible assets such as trademarks, patents, favorable contracts, trade secrets, and customer relationships. The actual fair value of these assets is opaque to an outsider who was not involved in the sale.
The sale price of a similar firm should define its value components—tangible vs intangible assets, real versus personal property, and taxable versus non-taxable assets—in order to be helpful for comparison purposes. The multiplicity of aspects may make the sale a less trustworthy measure of enterprise value, even if the appraiser can assign the different parts of value. Even if all of the essential data is available, the process of adjusting the value of comparables and the subject business is subjective, resulting in a valuation that is less securely defensible than one derived using a different valuation approach.
For these reasons, the market valuation method may provide some useful data points regarding the “going rate” for a similar business at a given point in time—but in many cases, it will not adequately assess the company’s actual fair value. However, the market approach is sometimes used as a merger and acquisition (M&A) valuation technique. In an M&A transaction, the acquiring company often anticipates achieving some type of business synergy through the acquisition of the subject business, and as a result, is not as concerned with establishing the exact value of the subject company when negotiating the purchase. The market valuation approach is also one of the most commonly used valuation techniques in finance.
The Cost Valuation Method
The cost method is based on the logic of the substitution concept. The idea is that wise investors will not pay more for a property than they would for a comparable alternative property. A cost method to value has two alternative beginning points, similar to the market approach: reproduction cost and replacement cost.
- Reproduction cost is the estimated cost, at current prices, to create an exact replica of the subject asset, using the same materials, construction techniques and standards, design, and quality of workmanship, and incorporating all the property’s deficiencies, over-adequacies, and obsolescences into this exact duplicate.
- Replacement cost is the cost to replace an existing property with a new one of equivalent utility, as of a specified date.
For obvious reasons, the replacement cost is more meaningful in terms of the principle of substitution; a prudent investor would not choose to replicate an existing property and incorporate obsolete, redundant, or unused features.
Using our example case of power plants, if a company is considering purchasing a plant that serves 100,000 people, it will not pay more for an existing plant than it would spend to build a new plant to serve the same 100,000 people. The cost of a new plant can be determined by figuring the cost of materials and the cost to build. The cost to build a new modern and functionally equivalent plant will typically be lower than recreating the existing plant. The new plant can be built in a less expensive, more efficient way, using the latest construction materials and techniques and the newest technology. The new plant will exclude obsolete equipment that is less efficient. Additionally, the new plant avoids the cumulative capital maintenance cost that creates “ghost assets”—assets that exist but are not used to functional capacity—on the books. The cost is then adjusted by depreciation to arrive at the current replacement value less depreciation of the subject power plant.
One advantage of the cost approach is that it is a very solid capital valuation method supported by current market costs and operating environment. Because the tangible property’s worth has been clearly separated from all other assets, it gives a definite value. The cost technique, when combined with the revenue approach, allows intangible assets to be evaluated indirectly. The enterprise value determined by the income approach is removed from the tangible values determined by the cost approach, leaving the value of intangible assets.
In terms of limitations, the cost approach requires a lot of reliable data. It requires calculating the costs of materials, equipment, and labor, and, for our example, developing information regarding the most efficient way to service those 100,000 customers. Finding and developing this information is very data- and time-intensive.
The Income Valuation Method
The income approach is based on the premise that a property’s current full cash value is equal to the current value of future cash flows it will provide over its remaining economic life. It is a classic approach to valuation but requires an extensive amount of detail and analysis. The income valuation method has the highest model risk—the risk that your model turns out to be inappropriate—as it relies on many assumptions. The effort required for using the income method will also, however, often result in a more accurate appraisal, especially when combined with other valuation methods. This approach allows value to be forecasted based on different scenarios and can be used to perform a sensitivity analysis.
There are several steps to applying this approach:
- Estimation of annual cash flows a prudent investor would expect to receive from the subject property over a defined period of time.
- Conversion of estimated cash flows to their current value equivalent using a rate of return that accounts for relative risk of the projected cash flow and the time value of money.
- Estimate of residual value, if any, at the end of the defined projection period.
- Conversion of residual value, if any, to its present value equivalent.
- Addition of the current value of estimated cash flows from the defined projection period to the residual value, if any, to arrive at the company’s enterprise value.
- Deductions for working capital, intangible property, and other excluded assets of the enterprise value to arrive at an indication of value for the subject company’s tangible assets.
The income approach is relevant if the goal is to arrive at a fair and defensible enterprise value. For situations such as establishing value for property taxes, however, tangible property needs to be specifically valued separately; the income approach does not allow separation by type of asset. The other limitation is that the calculated value is very sensitive to assumptions about the forecast period, the cost of capital, and the terminal growth rate derived; any small changes in these key assumptions can materially impact the assigned value. The COVID-19 pandemic provides a reminder that projections made years into the future may or may not hold true. Cost of capital projections should reflect the risk in achieving the forecast returns; clearly a new restaurant or hotel that opened its doors in March 2020 would not have performed as forecast in a business plan developed a year previously. Therefore, income-based valuations are most reliable for businesses with stable, predictable cash flows.
The income approach may be paired with the cost approach, allowing for direct value of tangible assets and indirect valuation of intangible assets, as previously mentioned. Intangible assets can also be represented individually, and the resultant residual intangible value from the business enterprise income method can then be compared. In addition to giving valuations for different types of assets, this integrated method will offer a defensible fair value for most instances where a company valuation is required.
Regardless of the reason for the assessment, determining accurate, defensible valuations for enterprises and/or company assets is a time-consuming and complex process that necessitates the expertise of seasoned valuation consultants. A company valuation specialist has the expertise and experience necessary to select the most appropriate valuation technique for your purposes and to establish a fair and accurate value.
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