August 27, 2019 — “What is my company worth?”
The road to answering such a simple question is paved with rigorous analysis and founded on a detailed methodology constructed by a valuation analyst. In today’s world, closely-held businesses are diverse organizations with complex characteristics to decipher when determining a value. No two businesses are alike and so, there isn't a valuation method that is universally accepted for all businesses.
Despite all the diversity in business characteristics such as size, business description, growth, and structure, a proper analysis as to the value of a closely-held entity still boils down to three main approaches: asset, income, and market. It is the application of these approaches and the thoughtfulness as to which of their numerous methodologies are applied by the analyst that give rise to a sound valuation conclusion.
Application of the approaches to value and their underlying methodologies need to match the purpose of the valuation and be based on the specific facts and circumstances of the engagement. When properly aligned, the results of the valuation will produce a conclusion that is supported by sound opinions and facts—and is most valuable to a business owner. For business owners, it is important to have an understanding of the valuation process, too, in order to have a productive conversation with the analyst. The direction of the conversation helps identify the most relevant facts and circumstances of the engagement that ultimately lead to the most appropriate path to a conclusion of value.
Very simply put, the asset approach calculates the equity value of a company by totaling the company’s assets and subtracting the company’s liabilities. Two main methodologies within the asset approach are book value and the adjusted net asset value.
As its name implies, the book value uses the historical cost as recorded on the balance sheet. While this methodology can work right after a transaction when costs are representative of the fair market value, over time the asset and liability values may deviate from historical cost and unrecorded intangible assets can be created. As a result, book value is not typically a methodology utilized in a business valuation.
The adjusted net asset method starts with book value and then converts all the assets and liabilities to their fair market value. It also accounts for intangible assets such as the value of a brand name, customer list, or the company’s reputation. For most operating businesses, the income and market approaches are a more efficient way to capture both the tangible and intangible value of the company and the asset approach is often not relied upon.
Despite the limitations of the asset approach with respect to goodwill, there are still practical reasons for this approach to be considered in every valuation. For closely-held businesses with large investments in stocks, bonds, and real estate (like family limited partnerships), the value of the company can be closely related to the value of the underlying assets. An asset approach can serve as a better measure of value than looking at the earnings capacity of the entity.
The adjusted net asset value, when analyzed for a liquidation, helps to determine the floor value of an entity. This is a practical hurdle to comparing values derived from income and market approaches in a controlling interest valuation. If values determined from other approaches are less than the established floor value, this raises some red flags: what are the reasons the business continues to operate or how efficiently is the business operating given that owners might be better served to liquidate assets and cease operations?
While the asset approach seems simple, a practical application of this approach is far more complex as analysts need to properly account for underlying assumptions related to factors such as standard of value, level of value, the premise of value, control versus minority interest, and built-in gains taxes.
The income approach is based on the premise that the value of an asset can be determined by estimating the present value of its expected returns. This approach considers the income generated by the investment, the risks associated with the investment, the timing of the anticipated income, and the growth of the expected income. Several methods are widely used in applying the income approach. These methods are generally classified as either capitalization or discounting methods.
Boiled down, the income approach at its most basic is just a fraction. The numerator represents a future payment to the investor, while the denominator represents the risk of the investment.
Value is always forward-looking. This income-based method focuses on the present value of the forecasted future benefits that would accrue to the hypothetical owner. This method requires an explicit forecast of the future cash flow streams over a reasonably foreseeable short-term period and an estimate of long-term cash flows that are stable and sustainable. These projected future benefits streams, along with the associated risk create a series of fractions that are then adjusted for the time value of money to determine their present value. The sum of the present valued future benefit streams is equal to the ownership interest—this method is most often utilized as it represents the most company-specific assumptions about the future.
This approach can also be referred to as single-period earnings. Just like the discounted cash flow method, it assumes that value is forward-looking and boils down to a fraction to determine value. Unlike the discounted cash flow method where multiple years are projected, a capitalization methodology relies on just a single period. Often the numerator is determined based on what the company has achieved historically. This single-period capitalization methodology is most appropriate when a company’s current or historical level of operations is believed to be representative of future operations and the company is expected to grow at a relatively stable and modest rate.
The income approach is the most often utilized in valuations as it best allows for the specific expectations of the company. Proper application of the income approach depends on the analyst’s ability to properly match earning streams to appropriate discount rates, determine both balance sheet and income statement adjustments through a normalization process (to correctly encapsulate an ongoing, recurring enterprise value), and apply appropriate entity level and ownership level discounts and/or premiums.
The market approach develops a value using the principle of substitution. This simply means that if one thing is similar to another and could be used for (or invested in) the other, then they must be equal. Furthermore, the price of two like and similar items should approximate each other. For the market approach to be used, there must be a sufficient number of comparable companies to make comparisons to or the industry composition must be such that meaningful comparisons can be made. The two primary methods within the market approach are the guideline public company method and the merger and acquisition method.
In the guideline public company method, a company’s value is determined by analyzing multiples at which publicly traded equity securities trade relative to various earnings or balance sheet parameters of that company. These valuation multiples are utilized to determine a company’s enterprise value by adjusting the market multiples to reflect a company’s risk and return versus the risk and return of the comparable companies. The steps of this method include:
In the merger and acquisition method, the value of the subject company can be determined by reference to sales of similar companies that have recently been purchased. These comparable transactions that have taken place in the private marketplace should provide a reasonable basis for comparison to the subject company’s investment characteristics. The merger and acquisition method is constructive as it represents true market-based pricing for the sale of similar companies. However, the available information on market transactions is oftentimes incomplete given the private nature of most comparable transactions. Still, the proper application of the merger and acquisition method is an important part of valuation analysis.
The market approach is an important consideration in any valuation as it often serves as a link to the real world in an otherwise theoretical exercise in determining value. It is easy to apply to company metrics and does not require a large set of assumptions like the income approach to derive a value. It is because of these advantages that analysts strive to use the market approach in every valuation even though it can raise questions as to the reliability of transaction data and motivations of sellers.
All three approaches play an important role in the determination of value for closely-held businesses. For business owners who have an understanding of the valuation process, this knowledge can help identify the appropriate facts and set of circumstances for the valuation engagement. The result is a well-defined analysis and helps ensure the business owner is presented with a valuation conclusion that will match the purpose for which the valuation was required.
Read Part 1 of this series: What Factors Contribute to the Valuation of a Company?
Read Part 2 of this series: The Difference Between Business Calculation and Valuation Reports
Read Part 4 of this series: Standard of Value: Recognizing the Differences
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