The need for a business valuation can arise in a variety of contexts, ranging from estate and tax planning to divorce, shareholder and other types of litigation. Valuation experts generally rely on three fundamental approaches – asset, market and income.
The circumstances surrounding the valuation determine which method or methods are most appropriate.
The asset approach weighs a business’s total assets against its outstanding liabilities. The valuation expert restates all of the business’s assets and liabilities, including those on the balance sheet and any material off-balance sheet items, at fair market value.
The adjusted liabilities are then deducted from the adjusted assets to reach net asset value. The expert applies any applicable discounts to convert the net asset value to fair market value.
The market approach considers objective market data for other businesses in the same general industry as the business under valuation. To value controlling interests, the method takes a transaction-based approach that looks at recent acquisitions of similar, or “guideline,” companies. Values for minority interests are determined by examining publicly traded guideline companies.
Perhaps the most important data of guideline companies are their measures of earning power, as earnings are essential to financing expansion and paying dividends. A valuation expert will multiply earnings and/or cash flow by price-earnings and price-cash flow ratios, which might be derived from the average ratios for companies included in market averages like the Dow Jones or S&P Index.
However, the blue-chip companies typically included in these averages may not constitute suitably comparable guideline companies, so the expert might instead rely on public companies with investment traits similar to those of the company to be valued.
Once the guideline companies are selected, whether valuing a minority or controlling interest, the expert performs qualitative and quantitative comparative analyses of the guideline and subject companies. Guideline company data are adjusted, and reasonable revenue multipliers formulated. The multiplier then is applied to either the subject’s revenue or earnings to reach the business’s value.
The income approach works from the premise that a business’s value equals the present value of the net cash flows it can reasonably be expected to produce in the future, as calculated by either the capitalization of earnings or discounted future returns method.
The approach can be used to value both minority and controlling interests by making appropriate adjustments to discount rates and cash flow streams. Further, it can adjust for variations in a business’s future results, although its accuracy depends on sound financial projections.
The income approach provides its most accurate value when the business has a historically high correlation between budgeted and actual results.
Selecting the right method
Circumstances can call for application of a certain method. For example, the asset approach works well for valuing holding companies, capital intensive businesses and businesses in such dire financial straits that a liquidation of assets may be necessary to achieve their maximum value.
However, this approach ignores a business’s earnings and represents an unreliable method for valuing profitable or going-concern companies, or businesses carrying significant intangible assets.
For such businesses, the valuator will likely rely on the market or income approaches or both. The market approach works well when valuing a minority interest, while the income approach can fill the gap when no reliable guideline company data is available or just to validate a market approach value.
Both approaches rely heavily on multiple layers of assumptions, so a single error will taint subsequent layers.
And a value reached with the income approach can swing dramatically as a result of minor changes in the selected earnings stream or discount rate.
David Gaynor is an executive with consultants Crowe Chizek and Company LLC. Reach him at (502) 588-8566 or [email protected].