There are three approaches to valuation as well as corresponding methodologies within each approach. Utilizing different methods under one or more of these approaches allows the appraiser to compare results to confirm the integrity of the final value. When valuing a closely held business, one size does not fit all!
By Erin D. Hollis, Accredited Senior Appraiser
For many married business owners, the business is both the most valuable and most illiquid asset in the marital estate – and if the owners separate, the business asset may spark substantial controversy and conflict between them.
Family lawyers frequently engage a valuation expert to assess a business’ value when working with divorcing owners. To obtain a credible and reliable valuation, you need an experienced and credentialed expert with technical know-how and a thorough understanding of the specific industry and best practices.
Three Approaches to Valuation: Income, Market, and Asset
There are three approaches to valuation – the income, market, and asset approaches – and within these approaches, there are various corresponding methodologies. Contrary to some opinions, there is no “one size fits all” application. In fact, it is understood among valuation professionals there are preferred methodologies for valuing certain types of companies, which are based in large part on the capital structure and financial operations of the business in conjunction with the consideration of the purpose of the appraisal.
The Income Approach to Valuation
This is the most commonly used approach for valuing a business. Based on the economic principle of expectation, the income approach assumes the business’ value is the present value of the economic income expected to be generated. The expected returns are discounted or capitalized at an appropriate rate of return to reflect investor sentiment and the inherent risks of the business. A business’ value is based either on future cash flows or historical earnings; the methods under this approach include the Discounted Cash Flow Method (DCF Method) and the Capitalization of Earnings Method.
The DCF Method is widely used when valuing a typical, growing business operation, such as wholesale or retail operations, manufacturing, contracting, and service businesses. It identifies the total value of a business as the present value of its anticipated future earnings in a specified period, then discounts the present value of anticipated future cash flows at an appropriate present worth factor. This method is often utilized when valuing companies for sale, acquisition, or to acquire capital infusion. It is also employed when valuing a company that is either projected to experience significant growth or has a finite life. Basically, any business can be valued utilizing this method as it examines how the business will financially operate over a defined period: e.g., five years going forward.
The Capitalization of Earnings Method is used when valuing very small, closely-held businesses, and in some cases, depending on the purpose of the valuation, mid-to-larger sized entities. The premise of this method assumes a company’s historical results are expected to continue with a relatively stable growth rate into the future. In many cases, particularly in the case of a small closely-held business, plans for expansion and growth do not exist or are not formally documented. With small, mature companies, the future typically mimics history, and shareholder expectations are not as focused on future financial performance or return on investment as they are on day-to-day operations. Start-ups, companies that anticipate growth based on a business plan, and companies that are in a transitional phase may all warrant a forward-looking valuation analysis utilizing the DCF Method. Conversely, a historical performance analysis may be required for tax purposes, such as estate and gift taxation.
Based more on judgment calls than technical calculations, the Capitalization of Excess Earnings Method was created by the IRS in the 1920s to value distilleries put out of business during Prohibition. It is sometimes used to calculate the intangible value that tangible assets generate for a closely-held business. Although not widely accepted in the business valuation industry due to the fact it relies heavily on the judgment of the appraiser, it may be used in circumstances where, for example, a business is heavily invested in equipment, such as a small transportation company. This method has been cited in marital dissolution state case law; however, its reliability is profoundly suspect due to the unsubstantiated calculations of the rate of return on both the tangible and intangible assets.
The Market Approach to Valuation
The market approach is based on the principle of substitution. Methods under the market approach include the Guideline Publicly-Traded Company Method and the Guideline Transaction Method. The market approach is predicated on the theory that the fair market value of a closely held company can be estimated based on the price investors are paying for stock of similar companies. This is done using ratios that relate the stock prices of the public companies to their earnings, cash flows, or other measures. By analyzing the financial statements of analogous companies and then comparing their performances with those of a subject company, the appraiser can judge what price ratios are appropriate to use in estimating the market value of the entity.
For example, examination of market multiples may give a perspective on the types of buyers, demand, and rates of return for a given entity in a given industry. Keep in mind, however, that multiples are specific to that transaction and point in time. They cannot be applied to every company due to a multitude of company-specific risk factors, including management, clientele, market share, and financial condition. As such, the market approach may be best applied as a sanity check to values derived from other methods, such as a method under the income approach.
The Asset Approach to Valuation
An asset approach may be applied when the benefits of operating a business do not outweigh the value that could be derived through an orderly liquidation of assets. Methods under this approach include the Net Asset Value Method and the Adjusted Net Book Value Method, which both assume a controlling premise of value. The asset approach is typically utilized to value the entire enterprise value rather than a non-controlling ownership interest or a pro-rata ownership of less than 51%. This is because only a controlling ownership can dictate a business’ capital structure or the sale of business assets, among other controlling shareholder characteristics.
The Net Asset Value Method is calculated as the business’ assets minus existing liabilities. This simplistic approach is commonly used when valuing securities of businesses involved in the development and sale of real estate, investment holding companies, and certain natural resource companies. This method assumes the book values of the assets on the company’s balance sheet are equivalent to their fair market values. However, the Adjusted Net Book Value Method involves adjusting the book value of the assets and liabilities to their current fair market values. The value derived from this method assumes there is no expectation of intangible value or commercially transferable goodwill. The Adjusted Net Book Value Method may be also applied when valuing an investment or real estate entity, when all business income is attributable to personal goodwill of the owner or key person, or when the value of the net tangible assets exceeds that of the company’s value as a going concern. An asset approach methodology may be used to value companies that are winding down or companies that are not profitable and have no expectation of becoming profitable.
By excluding an asset approach in a valuation analysis, the appraiser assumes that an investor would evaluate the company based upon its earnings and cash-flow-generating potential rather than through an appraisal of the underlying tangible assets, which would not reflect the intangible or economic value inherent in the company.
Using Different Valuation Approaches and Methodologies to Support Your Conclusion
The type of business and its financial condition, the particular industry, and the reason for the appraisal all dictate the appropriate methodology for a valuation analysis. Utilizing different methods under one or more of these valuation approaches allows the appraiser to compare results to confirm the integrity of the final value, and to eliminate a conclusion that may result from an erroneous “one size fits all” application of the three approaches.
Erin D. Hollis (ASA, CDBV) is Director of Financial Valuation at Marshall & Stevens Inc. She has experience in both the United States and Canada for valuation services including shareholder buy-outs/buy-ins, ESOPs, family business disputes, and marital dissolution. A qualified expert witness, she has testified in family law matters. www.marshall-stevens.com
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