What are the Reasons for a Business Valuation?
There are many reasons for a business valuation, including legal, regulatory, compliance and strategic. Some scenarios include:
- when shares of a business are gifted to family members
- as part of a divorce settlement or
- when trying to set a price in a sales transaction.
What is a Business Valuation?
According to the International Glossary of Business Valuation Terms:
“the act or process of determining the value of a business enterprise or ownership interest therein”
Ultimately, the value of a business is worth what another party is willing to pay for it. As an example, with regard to real estate, you can put your house up for sale. The asking price is typically based on similar sales in the area for houses with similar characteristics. Sometimes a homeowner will add or discount the price based on specific qualities of their home. Buyers will put in bids usually lower than the listing price but sometimes at a premium. As with real estate valuations, business valuations serve the same purpose. A valuator will arrive at a reasonable conclusion of value using industry accepted approaches and relying on professional standards and guidelines.
Step 1: How Are Valuations Done?
There are three main approaches to determining the value of a business including the Asset Approach, the Income Approach and the Market Approach.
- The Asset Approach is sometimes referred to as the Cost Approach. What would it cost to build a business from scratch? What is the business worth if we adjust the balance sheet to market value? This is a good approach for businesses with intensive assets such as Real Estate Investment Trusts (“REITS”) or businesses going out of business with valuable assets such as heavy construction contractors. Often performed but not relied upon, it is seen as a floor value for businesses operating as a going concern. This approach does not consider the intangible assets of the business such as goodwill.
- The Income approach considers the earnings capacity of the Company. For companies with a stable growth pattern, the Capitalization of Earnings Method is used which looks at historical earnings and capitalizes it based on an appropriate capitalization rate. When companies anticipate variability in growth in the coming years or have experienced volatility in recent years, the Discounted Cash Flow Method is employed. The Discounted Cash Flow Method takes projected earnings discounted back to present value using an appropriate discount rate. The Income Approach is almost always used in valuing businesses as a going-concern and appropriate in most industries.
- The Market Approach compares the subject company with peer company data. The Guideline Company Method derives multiples of public company data and applies them to the subject company data. This is appropriate when the subject company data is similar to the public company data in terms of size. It is considered highly reliable since it is using real-time pricing information. However, it typically is not used for small businesses as they are not usually comparable. The Completed Transactions Method derives multiples from actual ompleted transactions of privately-held businesses and applies them to the subject company data. There are several subscription-based databases that collect privately-held transaction data. This method is often used in small business valuations.
Step 2: How do You Reconcile the Different Approaches Used?
A valuation analyst will consider all three approaches. Often, several approaches and methods will be used and the analyst will need to reconcile differences that each method produced. An attempt should be reasonable made to understand why conclusions of value for each method varies. Choosing one method over another will depend on the specific circumstances of the valuation engagement and an analysis of the inputs used for each of the methods employed. Experience, industry norms and subjectivity all influence the decision on which method the valuator selects.
Step 3: What’s Next?
The next step is to apply any appropriate discounts or premiums. This is dependent upon the asset being valued, the method relied upon and other pertinent factors of the valuation engagement. Most commonly, when valuing a small privately-held business, a discount for lack of marketability is applied to account for the subject company not being a liquid asset. Compared to the stock exchange where you can sell shares of stock immediately, privately-held businesses often take months to years to sell. A discount for lack of control is applied if the asset being valued is not a controlling interest. Likewise, a premium for control can be applied in some instances. There are lots of theories and studies to consider when coming up with appropriate discounts and premiums.
The Bottom Line
Business valuation is a fairly straightforward concept. However, experience is needed in order to accurately select and execute the appropriate methods. Skill and resources are required to develop appropriate discount and capitalization rates. Furthermore, determining appropriate discounts and premiums is a complicated but crucial component to a business valuation. The quality and accuracy of your business valuation will reflect the skill and talent of the person performing it.
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