Implications
Valuing a business is a very important job that often has huge consequences yet is often misunderstood by many high-level professionals. This article discusses the basics of many valuation methodologies.
Analysis
A Primer on Business Valuation
Even
though some of the largest cases that attorneys handle involve valuing an
entire business, very few attorneys can intelligently discuss business
valuation. The subject is not a part of a typical law school curriculum. Consequently, many attorneys and others feel
that appraising a business and appraising a piece of real estate (a process
with which most people in the business world are familiar) are the same
process. The truth is that there are a few very basic overlapping theories of
value, but few similarities beyond that.
Methods
for Valuing Businesses
There
are many methods for valuing a business due to (1) the unique nature of each
business, and (2) the purpose of the valuation. Here is a rundown of a baker's
dozen of the most common approaches to value:
Market
Comparison Approach - Compares the market value of the subject business with
that of similar businesses. While this may seem similar to the market data
approach used in real estate valuation, the business valuation process is much
more difficult since there is no common yardstick for measurement, such as
dollars per apartment unit or dollars per square foot of rentable office
building, shopping center, or warehouse space.
Instead, you only have the equity (net worth) of the businesses, and the
concomitant problems of variations in levels of equity, relative size of the
businesses, locational and market differences, differences in the level and
quality of services or products offered, and other unique features of each
business that require prudent adjustments in order to result in meaningful
value numbers.
Replacement
Value Approach - Measures value by determining what it would cost to replace
the assets and business processes used by the business today. Differs from the
Market Comparison Approach in that this approach deals with acquiring the parts
that make up the whole business rather than looking at prices for the entire
business, as does the Market Comparison. Often used in settling insurance
claims.
Future
Net Operating Income Approach - Uses the present value of reasonable future net
operating income. Useful for a prospective purchaser whose chief interest is
the business's future net income. Due to the speculative nature of this
approach, great attention must be given to the bases for the projections of
future revenues and expenses. Likewise, the rate at which those future earnings
are discounted to a present value must be sound.
Historical
Net Operating Income Approach - Takes the actual net income figures for the
last few years and capitalizes them into a value figure. Any factors that
caused any year to have higher or lower than typical earnings must be
considered and adjusted.
Going-Concern
Value - Basically the value of a company as an operating entity. Often used in
conjunction with other approaches in order to determine a residual goodwill
amount (i.e., organizational value).
Often used in income tax valuation situations.
Liquidation
Approach - The reasonable prices for the various assets or business entities
that make up the business are calculated and totaled. Assumes that the master
entity is ceasing to carry on business and is selling its parts in the most
advantageous manner. Often applied to businesses that have a strong underlying
asset value but a poor earnings performance record.
Formula
Approach - Earnings, dividends, and book value are considered in this approach
and weighted in accordance to their appropriateness to the particular company
under consideration and their importance to the acquirer.
Capitalization
of Dividends Approach - Looks upon an acquisition more as an acquisition of an
investment security that will be held indefinitely. While it is a unique and
limited approach, it is appropriate for some circumstances, and can be used as
an indicator of value for consideration in some difficult evaluation cases.
Debt-Free
Approach - Permits an analysis of the company's operations without
consideration to the present debt structure. Allows a prospective purchaser who
might acquire the business and pay off the existing debt to see what the
business might be worth under those circumstances.
Reconstructed
Capital Structure Approach - Similar to the Debt-Free Approach, this
methodology allows a prospective purchaser to see what a company would be worth
with different capital and debt structures.
Typically, several competing debt and equity structures will be examined
and compared.
Capitalization of Future Cash Flow Approach - When there are large non-cash deductions from income and when the owner or acquirer is more interested in long- term growth of his or her investment, this approach might be more meaningful than the capitalization of past or anticipated net income.
Capitalization
of Historical Cash Flow Approach - Actual cash flows over the most recent years
are capitalized. Assumes that the business will continue to operate in the
future as it has in the past.
Adjusted
Book Value Approach - Starts with the company's most recent financial
statement. Then the values of the assets and liabilities are adjusted to
reflect current values rather than historical values that may be inaccurate
from a market value standpoint due to depreciation deductions, increases in
asset value, collectability, payment terms, etc.
Tax
Value Approach - In valuing a business's taxable real and personal properties
for ad valorem tax purposes, it is typical to rely more heavily upon the
assessed values of other similar properties than you would otherwise consider.
Real estate is part of a business, but generally is not valued separately -
except in special circumstances, such
as where a business has excess real estate that has a significant market value
and is capable of being sold separately without negatively impacting the
remaining operations of the business.
How
Not to Value A Business
Financial
Statements - Do not rely on the stockholders' equity or net worth figure on the
company's financial statements. They are
only useful as a starting point. Some
assets, such as real estate, are probably carried at depreciated values that
are lower than their market value. The financial statement may contain some
intangible assets that are incapable of being sold separately.
Spreadsheet
and Mathematical Models - Do not use a comparative spreadsheet model, or an economic
consultant that relies on one. Many analysts (MBAs are notorious for this)
think that they can simply develop a clever spreadsheet model, insert the
appropriate inputs, and voila, a value figure pops out like a piece of toast.
This weak methodology does not allow for the many differences that probably
exist between the subject and the companies used as a basis for setting up the
comparative spreadsheet.
In-House
Hired Help - If the valuation issue with which you are dealing could possibly
go to trial, do not use an in-house person from the company or bank as your
expert. You will never convince a jury that the person has any objectivity or
would be capable of voicing any opinion that was contrary to the interest of
his or her employer. Spend the few bucks
it will take to obtain a credible estimate of value.
CPAs
- Do not use a CPA to value a business. Their service is accounting, which is
basically making sure that numbers track and go in the right places. This is totally different from determining value. It just so happens that the financial
statements that they produce have a net worth figure, but it was explained supra that these figures cannot be
relied upon as meaningful indicators of value until they have been subjected to
numerous adjustments that are beyond the scope of a CPA.
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