When it comes to company valuation, the phrases appraisal, valuation, and evaluation are frequently used interchangeably, which begs the question: what is the difference between valuation and evaluation, and what is the difference between a business appraisal and a valuation? Is there any distinction between these terms? And, assuming that’s the case, what do they all mean? Opinions on the differences—or whether they have any difference at all—are all over the place. A Google search for evaluation vs. valuation, market appraisal vs. valuation, or any combination of the terms (valuation vs. evaluation, valuation vs. appraisal, etc.) will turn up a slew of articles attempting to differentiate the two. In reality, however, the phrases are interchanged, and there is no legal distinction between the definitions, nor has any official organization assigned a definite difference of meaning. Instead, valuation firms and appraisers appear to have their own opinions on the terminology and how they differ, if at all. We’ll compare these terms, their definitions, and the processes they’re used to describe in this article.
Valuation vs. Evaluation
We regard company appraisal and value to be interchangeable concepts at Taqeem. There is, however, a distinction between evaluation and valuation. A valuation is a professional report that covers all areas of value with accompanying documentation, whereas an evaluation is a more informal, ad hoc assessment. Others may define them slightly differently or conclude that there is no difference. The distinction we make is as follows: We conduct evaluations of financial reports, assets, comparables, multiples, and other sources of information in order to generate valuation estimates and reports.
That said, it’s not a distinction worth devoting a lot of time or thought to. In practice, appraisal, valuation, evaluation, and even assessment are often used interchangeably in conversations about corporate valuation; the context in which they are employed is more relevant. “We completed an appraisal of the company and found its value is X,” a valuation expert might state, while in fact he or she is outlining the whole valuation process that culminated in a formal report.
The process for determining the value of a business or business assets is most significant in a business valuation, whether it’s called a valuation, appraisal, or evaluation.
Business Appraisal Or Valuation Process
The process for establishing the value of a business follows a series of steps:
- Establish the purpose for the valuation.
- Determine the standard of value.
- Determine the basis of value.
- Determine the premise of value.
- Review the past performance of the business.
- Determine the future outlook for the business.
- Select and apply the appropriate valuation approach or approaches.
- Apply discounts.
- Formulate a conclusion of value.
As noted in this article, several steps in this process will determine the complexity of the valuation:
- The purpose for the valuation will often dictate the valuation approach or approaches to use, and has the biggest impact on the complexity involved in establishing value.
- The purpose for the valuation and the characteristics of the Subject Company will impact the effort required to gather and analyze data for the valuation.
- The type and number of valuation approaches required to establish a value will impact the effort required to both gather data and calculate value.
Once the purpose of the valuation is determined and the standard, basis, and premise of value are established, the appraiser collects the data needed to review the company’s performance compared to similar companies, make projections, and calculate value.
Data Required For Valuation
To appraise assets and analyze financial performance, a company’s valuation needs, at a minimum, an examination of the Subject Company’s financial statements, legal agreements, ownership structure, and stock metrics (if the company is publicly traded). It also necessitates data on the assets and financial performance of similar organizations for comparison.
That is the bare minimum; in some cases—particularly valuations that require calculation of value using the cost approach—far more data is required, as detailed in the next section.
Appraisal Or Valuation Methods
The market, cost, and income methods are the three ways used to determine the worth of firms and commercial assets. Each strategy has benefits and drawbacks, as well as situations in which it is best suited.
Market Valuation Methods
There are two different approaches to valuing a business using the market valuation method:
- Analysis of comparable publicly-traded companies’ value indicators: In this approach, the appraiser looks at the price/earnings ratio and other value metrics of similar companies’ stocks, calculates the averages, and applies the averages to the Subject Company. While this method is a relatively quick and easy way to estimate value, estimate is the key word—this method is very imprecise. That’s due to the fact that markets can under- or over-value companies, and the difference in multiples among similar companies may be due to specific factors unique to the individual companies.
- Analysis of comparable sales: As with real estate comparables, this method analyzes the recent sales prices of companies similar to the Subject Company. To account for differences between comparables and the Subject Company, adjustments are made. The drawbacks to this approach can include a lack of comparable transactions in the market, a lack of credible sources to support independent verification of value, and subjectivity in making value adjustments to the comparables and Subject Company.
The market valuation approach estimates the market rate for similar businesses at a given point in time, but it does not provide a final fair value for the Subject Company in most circumstances. This method, on the other hand, is sometimes used to determine the worth of mergers and acquisitions (M&A). In finance, the market approach is also a widely utilized valuation method.
The Cost Valuation Method
The cost method to value is based on the substitution principle. According to this theory, wise investors will not pay more for an asset than they would for an equal-valued alternative asset. The cost approach, like the market approach, can be applied in two ways: reproduction cost and replacement cost. Because a wise investor would not choose to replicate an existing property with obsolete features, the replacement cost method better accords with the principle of substitution. As a result, reproduction cost is not frequently employed in cost-based appraisals.
The Subject Company is duplicated from the ground up in the cost valuation approach, with current market pricing used to compute the cost of replacing all of the Subject Company’s assets. Because it eliminates all obsolete or underutilized assets, the replacement cost is typically lower than the Subject Company’s book value. The value is then adjusted for depreciation, lowering it even further.
The cost approach is a sound capital valuation method that is based on actual market costs and gives tangible assets a clear worth. It can be used in conjunction with the income method to indirectly value intangible assets by deducting the cost approach’s value of tangible assets from the income approach’s enterprise value. Its main drawback is that it necessitates a large amount of trustworthy data, as well as the calculation of the materials, equipment, and labor costs required to replicate the Subject Business. The time it takes to do the research and analysis required to calculate value using the cost approach is considerable.
The Income Valuation Method
The income approach is based on the idea that an asset’s current full cash value is equal to the present value of future cash flows it will create during the asset’s remaining economic life. Although the income approach is a traditional method of valuation, it involves a lot of information and study, and it has a lot of model risk because it relies on a lot of assumptions.
There are several steps to applying this approach:
- Estimation (forecast) of annual cash flows an investor would expect from the Subject Company over a defined period of time
- Conversion of those cash flows to their present value equivalent, using a rate of return to account for risk and the time value of money
- Estimation of residual value at the end of the projection period
- Conversion of residual value to its present value equivalent
- Addition of the present value of estimated cash flows from the projection period to the residual value to calculate the Subject Company’s enterprise value
- Deducting working capital, intangible property, and other excluded assets of the enterprise value to determine value of the Subject Company’s tangible assets
For estimating a fair and defensible enterprise value, the income technique is useful. The income approach, on the other hand, does not allow for separation by asset type in circumstances where tangible assets must be assessed individually, such as when determining value for property tax purposes. This flaw can be overcome by combining the income and cost approaches, which allows for the direct valuation of tangible assets as well as the indirect valuation of intangible assets.
The income approach’s reliance on assumptions about the forecast period, the cost of capital, and the terminal growth rate is a more serious flaw. Small adjustments in these assumptions can have a big impact on the value you get out of it. The future is unpredictable, and predictions made years in advance may not be accurate. Because of these drawbacks, the income method is best suited to enterprises with consistent and predictable cash flows.
After a value has been calculated using one or more of the above valuation methodologies, it must be adjusted for the following discounts, which may affect the value of the Subject Company:
Marketability discount:This discount considers the lack of ability to rapidly convert an ownership stake to cash
Key man discount:If the company is young or there is a lot of value associated with a particular individual, the impact of that person leaving could be substantial. Examples might include Apple and Steve Jobs, Tesla and Elon Musk, or Berkshire Hathaway and Warren Buffet. The value of each of these companies without the “key man” is likely to be less (and in the case of Apple, real-world experience illustrated the principle).
Control discount:If a minority stake in a private company is sold, a value adjustment needs to be made to account for this lack of operational and financial control. This can also apply in a public company but will have a much smaller impact.
The appraiser can arrive at a final judgment of value and produce the business valuation report once all appropriate discounts have been applied.
Regardless of the nomenclature used—valuation vs. evaluation, market appraisal vs. valuation, or valuation vs. assessment—determining the value of a firm or commercial assets is a complicated process that necessitates the expertise of skilled individuals. Experts in business valuation have the skills and information necessary to determine a reasonable and justifiable value for your firm.